Monday, August 31, 2009

Quick Look at Intermarket Correlations and Themes

Sometimes it feels as though it's all just one trade: the market is either rewarding risky assets or shunning them. Indeed, tracking intermarket themes during and across days provides useful information regarding the sentiment of large money managers.

I took a quick look at how three markets have been correlated since mid-2007 in terms of their weekly returns: U.S. dollar (UUP); commodities (DBC); and stocks (SPY).

U.S. dollar : commodities = -.57
Commodities : stocks = .39
U.S. dollar: stocks = -.25

If we just look during 2009, here's how the correlations shape up:

U.S. dollar : commodities = -.56
Commodities : stocks = .49
U.S. dollar: stocks = -.38

If anything, correlations have tightened up a bit during 2009. The negative relationship between the dollar and commodities makes sense, since commodities are in part denominated in dollars. A weak dollar implies a reflationary/inflationary outlook, which is positive for commodities.

As economies have picked up, the expectation is that economic growth would lead to greater commodity consumption; hence the positive correlation between commodities and stocks.

During the bear market, the U.S. dollar acted as a safe haven; those selling risky assets such as stocks fled to the safety of Treasury instruments and dollars. Now that stocks have been on the rise in the wake of economic recovery, there has been an appetite away from the dollar and toward the currencies of faster growing areas. Hence the negative correlation between the dollar and stocks.

An additional useful correlation to follow is Treasury yields. By observing the ebb and flow of these correlations over time, we gain insight into intermarket themes that drive capital flows.