Correlations Breaking Down

Before Wednesday we had started to see certain correlations in the market breaking down.  It wasn’t overtly obvious at first, a few hours here, a few percent there, but the idea was planted.  Things didn’t feel right a certain times, the dollar was moving up, but so were commodities, the market was moving up, but then commodities weren’t.  Today we got a full dose of some of the correlation trades we had been seeing come undone.  Let’s take a look back at three sections of time from the past year that may give us a playbook for what is to come.

The chart below shows the S&P 500, Gold, the US Dollar, and the 20 year treasury note.  I have highlighted three different sections of time from the past year.

Section 1 is all about deleveraging.  All real assets were sold off as everyone moved into cash.  Equities and commodities were slaughtered while the US dollar and treasuries rallied.  We had not seen this type of correlation in decades as everyone rushed to dump assets.  It’s very hard to believe that we will return to this scenario in the near future.  This event was a once in a generation catastrophe, primarily caused by the failure of Lehman.

Section 2 is what I call the “fear trade”.  Equities took another leg down while investors took their money out of treasuries and put it into gold and the US dollar.  Many traders focused on the strong negative correlation between gold and the dollar during these months for direction in their trades.  The most interesting thing though, is the positive correlation between the US dollar and gold.  It isn’t often that we see both moving in the same direction, this was a rare instance.

The “fear trade” ended in March as traders began to sell their dollars in favor of equities, especially of foreign descent, and other hard assets such as copper and crude oil.  The world no longer feared massive deflation as they had only a few months before.  They now turned their attention to the threat of  massive inflation caused by the seemingly unlimited supply of money being pumped into the economic system by US central bankers determined to stave off a deflationary spiral.  The race for hard assets was on and there was nothing that investors wouldn’t buy.  In section 3 equities staged an amazing rally, fueled by high beta stocks which had been demolished during the deleveraging period.  Gold, equities, and crude oil tracked each other as the more historical negative correlation between these assets and the US dollar resumed.  Treasuries continued their slide during this period as well.

And now we come to section 4 which represents the last 3 weeks or so.  The correlations that have held solid throughout the asset reflation, chase for hard assets, buy the crap period, or whatever you want to call it, seem to be coming to an end.  Equities have taken a nice smack in the face over the last few day along with crude oil and copper as gold and treasuries have rallied.  The dollar hasn’t done much of anything frankly, which takes away the weak dollar explanation for the rally in gold.

The move into treasuries and gold over the past few days, and the breakdown in significant correlations looks an awful lot like the “fear trade”.  I believe we may be seeing the end to the chase for hard assets period.  Investors are slowly taking money from equities, both foreign and domestic, and placing it in gold and treasuries for safe keeping.

Frankly I don’t much care why investors in equities and many commodities want out.  If you ask me, the chase for real assets was a joke in the first place.  That said, the market can be irrational longer than you can stay solvent, which is why you must trade what you see and not what you feel.  Too many clichés for you?  I don’t care.

I took long positions in $GLD and $TLT today as they came across my screens.  Silver ($SLV) also crossed my screens, but I avoided taking that entry due to its strong correlation with gold.

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