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Go Your Own Way: Correlation Breakdown in the Market


Gone is the simple asset inflation/dollar devaluation trade.


"In particular, I'm concerned that one of two things must happen in the years ahead. Either the US dollar must further devalue, as it has to the tune of 25% since 2002, or asset classes will deflate in synch. I'm unsure if these are mutually exclusive events but we'll likely jockey between the two as we figure it out. I will also offer that the greenback will serve as a proxy of isolationism as America delicately dances through a difficult war and sets protectionist policies in place."

A pretty sharp guy made those observations seven years ago. While I wasn't there at the Minyans in the Mountains retreat to hear Todd Harrison give that speech, I read those words and they struck a very well-timed and harmonious chord with me.

The message was timely and comforting as it seemed to align with many insights I was arriving at on my own. It was a confirmation that what I was seeing and wondering about wasn't just a function of my own delusional perspective. And if I was wrong, I at least had a well-thought-out argument.

Still, that was almost a decade ago. Now, we're still cleaning up the detritus that came in the wake of a gargantuan housing and credit bubble.

However, the time for consternation and angst is over. Metaphorically, we got T-boned at the intersection by a crazy, reckless driver; the police took our statement and the accident scene has been cleaned up. There's no point in replaying the accident over and over again in our heads just as there's no point in counting down the days, weeks, or months until we're in another accident. If that's our response, we shouldn't get behind the wheel again. We'll only be a hazard to ourselves as well as others.

This got me thinking about how to reassess where we are, and where we could be heading.

If Twain's words about history rhyming – but not repeating – are true, then we shouldn't expect more of the same old policies from past recessions to work. After all, you don't drive the same way after you have a car crash. And you can't build a recovery on a damaged foundation.

In doing this reassessment, let's look at some charts. The first one is the S&P 500 (^GSPC) versus the CRB Index (CR-Y.NYB) and represents a look at stocks versus commodities going back 10 years.

The second one is the broad trade-weighted dollar index versus the CRB over the same time period:

The last one is the trade-weighted dollar index against the S&P 500:

There's nothing special about these charts at first glance. Commodities are inversely correlated with the dollar, and stocks have tended to follow suit. Indeed, the ten year correlation matrix shows this:

But that's just taking a snapshot of a lot of data points over a very long time horizon.

Correlations aren't static; we should've learned that from the performance of collateralized debt obligations by now. It would seem to make a lot more sense to see how correlations change over time.

So I took the data and broke it down into two different groups: May 2002 to May 2007 and May 2007 to May 2012. The results are presented below:

You'll see I highlighted the correlations between the S&P 500 and the CRB, along with the correlation between the S&P 500 and the dollar. Note how the relationship changed from the first time period (5/2002 – 5/2007) to the second (5/2007 – 5/2012). The S&P's correlation with the dollar has gotten more positive and its correlation with commodities has gotten more negative.

If we break it down further, we can better see how correlation changes over time. I made two charts where I look at both one year and two year correlations and recalculated them on a daily basis:

In both cases we see the tendency for stocks and commodities to be positively correlated during the recovery years while commodities and the dollar have held a persistently negative relationship, evidenced by their strong negative correlation (even though there have been small windows where the relationship was positive).

The most interesting piece, though, is the relationship between stocks and the dollar. If you take a look during the housing and credit bubble, stocks maintained a positive correlation with commodities while – for a brief period – there was also a positive correlation between stocks and the dollar.

The more telling thing to observe is the correlation breakdown on both 1- and 2-year charts between stocks and commodities that started about the time the September-October lows were put in. A rising dollar and rising stocks? What would that signify? Let's think about that for a moment.

There are a couple of differences between this recovery and the last. First, this recovery isn't being led by housing and financials, but largely on the back of other sectors in the economy like technology, energy, and health care. Second, where in the past we were willing to borrow our way to purchase things, this time around, we're not. And when we do borrow, we're borrowing less.

Issuance and usage of debt are, in their own way, a way to inflate growth. Take that away as a driver for the economy, and you find yourself faced with a different, slower path to growth.

But we've seen stocks continue to have solid earnings – and even improve their margins – while revenue growth has lagged. In this sort of environment, rising commodity prices, which used to be good for stocks, are now bad. So for stocks to continue their rise, we need to see the positive correlation between stocks and commodities continue to break down, or at least not revert back to the levels we saw in the past.

And of course, there's the macro environment.

Europe is playing the part of the gang that can't shoot straight while China and India are two countries confronted with their own slowdowns and hurdles to economic growth. You add all of that together and you get a scenario where the US starts looking like the prettiest house on a rather ugly block.

Ultimately, investing isn't about lamenting over the investments you want or you wish to have, it's about making relative risk/return choices on the opportunity set you do have. And right now, you could do a lot worse than investing in US stocks, especially ones where the bulk of their revenues come from domestic – not foreign – sources.

The question, of course, is whether or not this trend that started in the past eight months or so continues to keep moving forward. That, I don't know. But what I can tell you is that the time to start thinking about a new market meme to replace the dollar devaluation/asset inflation meme is now.

Twitter: @japhychron
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No positions in stocks mentioned.
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