Saturday, April 22, 2006

Sector Correlations You Should Know About

With the big moves in oil and gold and crosscurrents in the stock indices, it's worth taking a look at how sectors move relative to one another. We can do this by measuring the correlations of their daily changes. From November, 2004 to the present (N = 358 trading days), here are some correlations of daily price changes:

S&P 500 Index and Energy Stocks (SPY/XLE): .52
S&P 500 Index and Consumer Stocks: .84
S&P 500 Index and Gold (SPY/GLD): .08
Energy Stocks and Gold (XLE/GLD): .29
Energy Stocks and Consumer Stocks (XLE/CMR): .24
Gold and Consumer Stocks (GLD/CMR): -.03

Since the start of 2006, we've seen two interesting developments in the correlations:

Energy Stocks and Gold (XLE/GLD): .54
Energy Stocks and Consumer Stocks: .15

What this may be telling us is the following:

1) Consumer stocks are very weakly correlated with movements in energy and gold--much less so than other components of the S&P 500 Index.

2) Energy stocks and gold have increased their correlation with each other, in what I view as a "weak dollar vs. commodities" phenomenon.

3) Fully 25% of the variation in the S&P 500 Index (the square of the correlation) is attributable to moves in energy issues. Over two-thirds of the variation in the S&P 500 Index is attributable to moves in consumer stocks.

4) Sectors that benefit from the growing "weak dollar vs. commodities" phenomenon are more likely to outperform sectors that rely on consumer purchasing power, which may be doubly taxed by higher interest rates/mortgage payments and higher energy prices--at least until fiscal and monetary policy addresses dollar weakness. Such crosscurrents make it difficult to sustain overall strength in the S&P 500 Index, which is a hybrid of companies that benefit from and are hurt by high commodity prices.

5) My personal conjecture is that we won't see an outright bear market until higher interest rates--needed to attract capital to dollar denominated assets--weigh on a majority of stock sectors.