Correlations

I am flying to Singapore today so I am posting Thursday’s blog early morning Hong Kong time.

Yesterday I received two e-mails asking: “since you believe that Crude Oil is going to go down, won’t this mean the S&P will go up?”

The questions imply that there is a negative correlation between Crude and the US Stock Market i.e. if Crude goes down, the Stock Market will go up.

I ran some correlation studies; in fact the correlation between Crude Oil and the S&P is meaningful (90%) only in 2008. The farther back we go, the lower the correlation becomes. For correlations to be robust I like to see 90% over at least 15 years of data. Even in 2007, the correlation was less than robust.

Figure 1 is an example of what I mean.

07-16-2008-qm-correlation-sp.jpg

FIGURE 1 Correlation Crude Oil and S&P

We start at the 13-week (quarterly trend) S&P swing low. (Note I have not shown the Barros Swings for the sake of clarity). The Crude Oil 13-w swing low occurred earlier on January 18 2007.

Both markets went up until the S&P peak on July 16 2007. The S&P corrected down while Crude continued up until August 01 2007. The correction for the S&P ended on August 16 2007, while the correction for Crude ended on August 22. From August 22, both markets turned up until an S&P high occurred on October 11 2007.

The example is meant as an example to illustrate the correlation studies I did; it is not meant as evidence of a lack of correlation – the correlation studies do that.

The point is, be careful of “Wall Street Lore”. Sometimes the story has some merit; at other times, the story has no merit and at still other times, the current situation is an exception to the story. Speaking of exceptions, let’s turn to one.

“Bonds and stocks don’t move down together “.

The reason for this is when the stock market moves down, there is a flight to quality to Bonds that drives prices up (yields down).

Correlation studies show this is generally true. But, there is one exception: in periods of stagflation, Bond prices and the Stock Market can run in the same direction. For example, in 1972 to 1974, Bond prices went down (yields up from 5.73% to 8.70%) and the stock market also went down 38%. The critical question, therefore, is whether the US economy is set for a stagflation period.

I believe it is.

At the very best, the US economy can be said to be in slow-down mode. I say this to avoid getting embroiled in a discussion on whether or not the current state satisfies the technical definition of a recession. As Shadow Stats (http://www.shadowstats.com) points out:

“… real (inflation-adjusted) second quarter retail sales contracted for the fourth consecutive quarter, while the second-quarter industrial production showed a sharp quarterly contraction. In conjunction with consecutive quarterly contractions in payroll employments, these numbers should remove any doubt of the economy being in recession.”

Yesterday (CPI) and Tuesday (PPI), we saw the effects of the recent FED/Treasury bailouts seep into the inflation numbers. Shadow Stats tracks M3 growth and it shows a massive increase since August 2007; M3 peaked at a massive +17%. It currently stands at 16%.

Given what Bernanke said at his testimony on Tuesday and Wednesday, we can expect new liquidity moves – these will increase M3 even further. Based on this, Blind Freddy would see that the CPI will probably be reporting double-digit inflation in 2009.

I write this to lay the foundation for a possible long-term top in the 30-year Bonds. More on this tomorrow.

2 thoughts on “Correlations”

  1. Ray

    Reports said part of the reason given for yesterday’s intraday rebound in the stock market was the huge reversal in Crude Oil.

    Whether declining Oil prices are good or bad for the stock market is up for debate, but any drop in oil prices will certainly relieve pessimistic conditions about the economy and stock market.

  2. Ray

    Looks like crude will maintain its price…

    Gleaned from the news:

    Higher margins would have made it more expensive to trade in U.S. futures markets such as the New York Mercantile Exchange. Futures industry officials had warned that if margins were significantly raised, the United States would lose business to overseas exchanges or less-regulated U.S. markets.

    Still, Reid’s bill would require the Commodity Futures Trading Commission to distinguish between true hedgers, like airlines, that buy and sell oil futures to offset the risk of high fuel prices, and speculators who bet on the price of oil and never intend to take physical delivery of the crude.

    The CFTC would have to convene a panel of experts to help determine the tough position limits that should be imposed on speculators, which would restrict the number of oil futures contracts an individual speculator could control in a delivery month.

    Reid said on Wednesday that he hopes to bring the bill to the Senate floor for a vote “in the near future.” A Reid aide said the legislation may come up for vote at the end of this week or early next week.

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