Scary Correlations

Correlations

Fyodor O. Minakov

The inexplicable, synchronized daily ups and downs of global equity markets never made any sense to me, so I decided to try and find out what on earth was going on. I printed out a graph of the S&P 500 index and compared it against three other economic indicators hoping that I could make some sense of this apparently choreographed routine. As the first indicator, I chose Vanguard’s energy ETF, VDE, which is a basket of energy price averages that includes oil, natural gas, and coal. As a second indicator, I chose the stock of a single diversified oil and gas giant, Exxon Mobil, which boasts downstream (refinery and distribution), midstream (storage and transportation) and upstream (exploration and extraction) operations. Exxon’s stock price has typically during the last decade moved up and down with the price of oil, commodities, and energy in general. I then compared these three charts to an index that tracks the performance of the dollar against a basket of currencies.

What I noticed stunned me. The graphs of Exxon Mobile, VDE, and the S&P 500 seemed to resemble one another. The price moves of these assets followed almost exactly the same course, moving up and down in synchronized waves, while the line of dollar index was an imperfect mirror image of the other three indicators.

I had always believed that stock prices were a reflection of underlying value. The dollar, I had thought, moved up and down against global currencies as a function of supply and demand, not dancing as both lead and follow with equities and energy. The dollar, surely, would strengthen as a function of economic growth, and money supply, the underlying inflationary and deflationary trends that existed within the U.S economy.

Furthermore, I had thought that commodities tended to move up and down based on their abundance, demand, ease of production. These forces were the foundation of classical economic theory, taught all across the world in undergraduate and graduate universities. Not so; these avant-garde indexes were apparently  harmonized, stampeding across the world like so many virtual jackboots, stamping on market contrarians, economists, energy industry analysts, and supply and demand theorists with their fascistic tyranny.

John Maynard Keynes once said that “Markets can remain irrational longer than you can remain solvent.” What he meant by this is that you cannot expect fundamentals to reign supreme, and for the market to act as classical economic theorists would have you believe – rationally. Rather, when speculation sets in, which is quite often, the markets will behave as a pack of scared or excited wildebeest, trampling all those that move against the herd beneath their hooves.

 When hedge fund impresario John Paulson, famed for buying insurance claims on mortgage-backed securities during the financial crisis, lost money in May and June investing in gold miners AngloGold Ashanti (AU) and Gold Fields (GFI), I wondered what on earth the problem could have been, since the value of gold had been practically stable during that period. Why wasn’t the price of the underlying commodity buoying the price of the company that mined it? Why, in short, did these companies’ stock price moves resemble the S&P 500 more closely than they did the price of gold?

The core relationship between the S&P 500 and energy prices, namely oil, and their corresponding inverse relationship to the U.S dollar need explanation, and though the myriad complexities of weekly and monthly price moves may defy mortal understanding, at least to this writer, the general trends of negative and positive correlations must have some readily ascertainable cause.

First, we will tackle that odd chemistry between oil and the dollar. Oil is quoted in dollars and therefore maintains an inverse relationship to the currency that it trades in. For example, if oil is trading at $90 per barrel, this means that $90 will buy one unit of oil. Let’s say that oil moves up to $120 (heaven forbid!), the dollar can now buy 25% less oil than it used to, and has to be revalued. So, in effect, as the price of oil increases, the price of all other asset classes should increase proportionately, everything else being equal.

This explanation, however, only scratches the surface. Why would energy prices, which have a demonstrable and quite logical effect of decreasing GDP by increasing the cost of economic activity, increase in partnership with stocks that are ostensibly priced based on changes in corporate earnings? Speculation must be the culprit. Short term money, it seems, has lost the ability to distinguish between good company and bad, between the direction of oil, and stock market earnings. The dollar, in which stock market and oil prices are quoted, must respond to these asset flows by shifting upwards or downwards.

Learning fundamental analysis: P/E ratios, price-to-book, etc. has always been a rite of passage for amateur and professional investors alike. When I asked fund manager David Ellison, who presciently held 57% of his portfolio in cash in 2008, what he thought the rationale for these correlations was, he stumbled for a minute, and then intimated that spec, or speculative trades were the cause: “It doesn’t look like we’ve stopped speculating, right?” he said knowingly before proceeding to cite an example apposite to the case, drawing a long sigh, and then closing with words from his mentor, Fidelity’s Peter Lynch.

George Soros provides a compelling, albeit abstract, philosophical rationale for these correlations in his many writings on a phenomenon that he coined: reflexivity. Reflexivity is a way of describing the interplay between the competing forces of thought about reality, and reality itself. In other words, price affects assumptions about price, forcing markets upwards until a breaking point is reached. At this point, sentiment reverses course, and begins to force prices down, feeding a negative feedback loop that continues until markets appear too cheap.

The feedback loops between commodity prices and equities seem to be the same, as both are predicated not on supply and demand, but rather on expectations of economic growth or decline. When the economy is expected to grow, the price of oil increases, forcing the dollar down, which simultaneously forces the cost of buying U.S assets down, and money begins to flood into equities. As equity prices drive up earnings expectations of companies, this drives the futures market for oil higher, as assumptions about future growth are made. Traders, instead of reacting to long-term fundamentals, and even less so, global supply, demand, or cost of producing oil, react based on how they think other like-minded market participants will react. Everyone is always looking over their shoulder to see what the other guy is doing.

            The Efficient Market Hypothesis, which has dominated financial economics for the last forty years, has attempted to justify asset purchases on the basis that the market price is always right, justified, and tied to all available information. Anyone with half a mind who hasn’t been coaxed by their college economics professor or broker into believing this will surely ask… If markets are always right in their price, and base this price on fundamentals, how on earth does one explain a 60% drop in the S&P 2007-2009, and then the subsequent recovery in 2009-2010? This, as corporate profitability dropped only marginally during the recession.

The theory’s central argument serves to demonstrate that individuals that pick stocks by throwing darts have just as great a chance of beating the S&P 500 as professional money managers, and so it tends to be true in practice for reasons which we do not have time to discuss here. Still, an individual throwing a dart at a board in early 2009, having recognized that the market’s tail dive might be coming to an end, would have returned 40%-50% throwing darts at the right time. But the same theory that hypothesizes efficient markets also hypothecates fully invested asset distributions, which in practice means holding virtually no cash, except as an “appropriate” allocation. That the old rule of thumb, espoused by value investors, “buy cheap and sell dear”, tends to beat markets better than any balancing strategy, is perhaps enough to lay waste to the entire concept of efficient markets.

As information becomes increasingly perfect, albeit unevenly distributed, and money managers and traders try to mimic and “crowd out” each other’s investment strategies, the financial herd will continue to move in lock step. So far, the markets have shown no indication that they have changed fundamentally since the financial crisis, and in fact, the synchronicity between the movements of the S&P, commodities, and their respectively inverse relationship to the dollar has increased.

As long as the speculative spirit and short term money flows trump stable, long term allocations, and fundamental investing, the gambling culture will continue to reign supreme, and money managers will be forced to dance until the music stops. In the United States, where retirements are funded through money market instruments, pension funds, and direct stock ownership, the liquidity problems that arise from wild market swings can be devastating to individuals. Retirees caught liquidating assets at the wrong time will continue to suffer the agonies of a manic-depressive Mr. Market that has no sense, no direction, and no clear purpose.  In short, Americans are at the mercy of a perfectly insane course down Wall Street, standing helpless and mute as the market waves its arms, yells, stumbles and every few steps, spits great globs of spittle directly into their worried faces.