Pairs traders love it. Long-short and market-neutral funds swear by it. Macro money managers rely on it. What do they all need? Correlations.
Correlations can identify the intricate relationships between two securities or two markets. It is not easily identifiable unless one studies all the underlying raw data. When it comes to market analysis, traders and analysts use correlation analysis to analyze the quantitative data to determine the relationships, if any, discernable patterns, and significant connections between two variables (i.e., two securities or financial markets).
Some believe correlation analysis when utilized in portfolio management is overrated. There are not enough benefits from running correlation analysis among asset classes to achieve an excess return. It is only a tool for determining the specific risk associated with an asset class. Long-term correlations do not show the entire story because they tend to miss what occurs during shorter-to-intermediate term periods.
Others believe correlations can be a strategic and tactical part of trading and investing. The statistical indicator has become commonplace among traders, especially those that hedge their portfolios in today's fast-paced, volatile, and unpredictable market. They assert correlation studies can protect investors from cyclical shifts in the industry, sector dislocations, and other market risks. Understanding the relationship between asset classes and securities helps traders/investors better protect their portfolios against downside risks.
Traders find correlation analysis useful within the commodities market because commodities are like assets and complementary goods. Since commodities are raw goods that are used interchangeably across different industries, this lends the asset class to low operational correlation. The correlation that exists between commodities is tied to shared utilities. For instance, WTI Crude Oil is highly correlated to Brent Oil. Gold and Silver are also closely correlated because these two precious metals are forms of currency and inflation hedge.
One of the more popular and studied correlation analyses is the Stocks to Commodities ratio (SCR). It is especially appealing to many traders, money managers, and asset allocators. The ratio studies the relationship between the stock market (i.e., S&P 500 Index) relative to the commodities market (i.e., Producer Price Index - PPI). When the ratio rises, this implies stocks are outperforming commodities. When it falls, it suggests commodities are outperforming stocks. The ratio shows that over the very long-term or since the late-1800s, stocks have outperformed commodities.
Based on the SCR study, stocks and commodities are negatively correlated over an extended timeframe (generational trends). However, it is also evident that equities and commodities can deviate over the intermediate-term time horizon (structural trends), probably due to the fluctuations within the economic, business, and credit cycles.
Stocks excel during the early expansions and the late recessions phases of an economic cycle, while commodities outperform during the late expansions and early recessions phase. Equities and commodities also have well-defined periods of leading and lagging tendencies spanning every 8 to 20 years. Stocks tend to outperform commodities during deflationary cycles, while commodities outperform stocks during inflationary cycles. During periods of deflationary cycles, it often coincides with structural bull trends in the stock market and stable credit conditions. When the deflationary trend ends, inflation pressure begins, as evidenced by commodities bull rallies, geopolitical turmoil, and volatile credit markets.
Since 2009, or the start of the deflation cycle and hence the current structural bull in stocks, the question then becomes – how long can this trend sustain, and when is the next inflationary trend?