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Five Things: Revisiting the "All-One-Market" Theme


Record correlation hints of herd collapse.

1. Record Correlation Hints Herd Collapse

That's a rather mysterious headline, I agree. And it's typical of the kind you have to roll your sleeves up and dig through if you're picking through Bloomberg stories. But what it's really trying to say is fairly interesting.

According to Bloomberg, "the Standard & Poor's 500 Index, whose increase in the past three months was the steepest in seven decades, is rallying in tandem with benchmark measures for raw materials, developing- country equities and hedge funds. The so-called correlation coefficient that measures how closely markets rise and fall together has reached the highest levels ever."

The correlations between the S&P 500 and the Reuters/Jefferies CRB Index rose to 0.74 in June (1.00 would mean the two move identically). According to Bloomberg, the previous high was 0.66. The correlation is similar between the S&P 500 and crude oil and emerging markets, both at or near record highs in correlation readings.

2. All-One-Market Theme

When I was discussing an increased correlation in 2004 among all risk assets - the "All-One-Market" theme - the main point was that excessive liquidity flooding the economy in the wake of the 2000-2002 dotcom collapse would destroy non-correlation of assets until a saturation point of credit demand and risk was reached.

Fast forward to July 2006 and we began to see a decoupling occur in certain sectors as that sautration point began to materialize:

From July, 6, 2006:

"We've talked before in Minyanville about the "all-one-market" theme; the effects of excessive liquidity combined with excessive speculation and excessive appetite for risk (credit). In this all-one-market theme, all financial assets rise as one and non-correlation of assets is destroyed as the excess liquidity floods the market... everything essentially becomes one. This is why the charts of the Sensex, Gold, Copper, Sugar, the BKX, whatever you choose, all look about the same since... anyone? anyone? March 2003. However, what I believe this chart (see below - iShares Real Estate ETF (IYR) with PHLX Housing Sector Index (HGX) overlaid) shows, this recent decoupling, is what happens when the saturation point for credit and risk is reached. Loquidity-fueled markets, as we have seen, rise together as one until the appetite for risk adn credit (speculation) becomes saturated. Then the decoupling beginsm which we are now seeing. But this decoipling is only temporary. Eventually those that are holding up will resume their correlation, only this time on the downside."

iShares Real Estate ETF (IYR) with PHLX Housing Sector Index (HGX) overlaid


Ok, so that was the origin, the tipping point if you will, of the retreat in risk appetites that began in late 2006. Bloomberg is worried about this increased correlation once again. I am too, but from a different perspective: What I am looking for now is for decoupling to occur on the downside.

It is now fully accepted conventional wisdom that any "improvements" in the broad economy are simply the result of government engineering and fiscal stimulus masquerading as growth. I'm not going to disagree that this is the case. But I want to look a bit farther out. Rather than monitoring the "collapse of the herd," what I want to monitor are any signs that decoupling on the downside is occurring, especially as stocks face a difficult second half of the year as I expect.

The bottom line is this: the conventional call to make from here is that the economy is going to worsen and that stocks are going to fall back into line with economic reality. I want to look a bit farther out and see which sectors can weather that second half storm, as I believe some will.

3. The Quiet Americans

For still more reasons why deflationary pressures continue to far outstrip potential inflationary pressures, take a look at this article from The Economist magazine, "The Recession and Pay: the Quiet Americans."

According to a survey for the magazine by YouGov, 13% of Americans have taken a pay cut this year. And even as unemployment has surged this year, the average work week has shrunk with ourly wage growth slowing considerably.
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