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Whose Move Is It?

Markets have been surprisingly quiet over the last few days. Some of that, no doubt, is due to the NCAA basketball tournament, to the Good Friday/Easter Monday holiday in the U.S. and in Europe, and to baseball’s Opening Day.

We also had Japanese year-end and the end of Q1 in the U.S., and to the extent that the last week has brought any market moves of interest at least a portion of that can be put on the account of the calendar. On Thursday, the S&P set a record month-end close, although a higher intraday print was established in October of 2007. But while news accounts attributed the almost-record to an “easing of Cyprus fears,” it is much more likely that it was due to the normal (and well-known) quarter-end “mark ‘em up” machinations of less-scrupulous fund managers in illiquid market conditions.

In a similar vein, the quirk of having the quarter end on a Thursday three days before the calendar turns helped exaggerate a massive move in grains, especially corn, on a mildly bearish crop report. Those who are invested in commodities for tactical reasons are being flushed because they’re tired of waiting, as an article in today’s Wall Street Journal made clear. The investors who are leaving do not have comfort in the asset class because they don’t understand the drivers of the asset class; the result is that they become performance chasers. So, when crop reports suggest that the real price of corn should fall a little bit, investors slash nominal prices 10% in ‘get me out’ orders.

But as I said, these investors don’t understand the fundamental drivers of the asset class. The article cited above regarded the breakdown of the correlation between commodity indices and equity indices as something sinister, saying that the correlation is at its lowest level since 2008 and suggesting that this means that one of the two markets is wrong. As it turns out, though, the correlation of stocks and commodities is a relatively new phenomenon. Over the last 5 years, the correlation of monthly changes in the DJ-UBS index and the S&P is 0.61. However, for the 17 years prior to that, the correlation was 0.04 (see chart, source Bloomberg).


For the GSCI commodity index, the last-5-years correlation is 0.65, but for the 38 years prior to that (the GSCI has a longer history) the correlation was -0.02. In short, there is no reason to read a whole lot into the recent decoupling of stocks and commodities, except that it may suggest the hot money is finally leaving commodities. The correlation breakdown is also a good thing for anyone who believes – as I do – that stocks are overvalued. And, since a good portion of commodities’ long-run return comes from a rebalancing effect that is larger when the inter-commodity correlations are lower, this is more good news.

The choppy melt-up in stocks on Thursday was partially reversed by the new-quarter blues today, but all of this is mere detail. Over the last week, while authorities in Europe have encouraged investors to put the Cyprus issue to bed additional details have emerged that deserve mentioning. For example, it turns out that the larger depositors (over €100,000) investors in one of the Cypriot banks will not get a 10% haircut, or a 20% haircut, but something close to a 100% haircut – 37.5% of the deposit balance in excess of 100k will be converted to equity in the bankrupt bank. There are some reports that certain deposits belonging to “EU funds” will be exempt from the haircut. There are of course the stories that capital controls implemented in Cyprus were ignored in non-Cyprus branches of Cypriot banks, and one Cypriot newspaper is claiming that relatives of the president withdrew substantial funds from Laiki bank just before the bank was shut down.

While the worst of the immediate crisis has surely passed, it seems madness to me to pretend that it never happened or that it will have no knock-on effects. For that matter, it seems madness to conclude that since the knock-on effects were not immediate, that no such effects exist. On the other hand, when events are no longer going bang-bang-bang in rapid succession, it is reasonable to ask “whose move is it?” Will bank deposits begin to flee from periphery countries, or wait to see what assurances European officials give? Are central bankers already injecting liquidity into shaky banks, or are they waiting for the invitation from the banks in-country? Are investors reducing risk and diversifying away from European assets, or are they waiting to see if other investors do so first? All of these actions entail costs, and so there is a natural desire of every party to delay action…but to not delay action so long as to cause those costs to rise substantially.

As a trader, my inclination is to hit a bid and get out, and not worry about the bid/offer spread or those other costs. But I am not dealing with billions of Euros when I do that. Still, the insight is that when bad things might happen, the here-and-now transactions costs are usually a poor reason not to seek protection. This is why T-Bills over the last couple of years have occasionally had negative nominal yields (see the chart of 3-month T-bill yields below, source Bloomberg). Yes, it’s clearly dumb to pay $1.01 now to receive $1 in the future. But is it dumber than the alternatives?


  1. Eric
    April 1, 2013 at 3:44 pm

    Agricultural commodities look very attractive to me at these levels–especially if, like me, you believe climate change is real. I understand your point about fluctuations in real prices being somewhat irrelevant to the investment merit of commodities, but…I don’t think last summer’s crop shortages were a fluke. And unlike industrial metals and such, demand for food doesn’t decline so much in a declining world economy.

    • April 1, 2013 at 10:07 pm

      Thanks. I don’t disagree at all…as a trader, these look sorta stupid to me.

  2. Eric
    April 1, 2013 at 3:47 pm

    A second small point: I couldn’t agree more with your comment about it being a good thing for the correlation to break down. Nothing would make me happier than if the whole “risk on/risk off” dynamic were to go away. That dynamic makes it hard to want to invest in anything.

  3. HP Bunker
    April 1, 2013 at 5:02 pm

    Mike, Is there a particular commodity etf (or etn) you recommend? In your past articles (and this one) you’ve referenced DJP, but I wasn’t sure if that’s a recommendation or just used as a proxy for the commodity market generally. Thanks.

    • April 1, 2013 at 10:08 pm

      We use USCI. If you search my articles you’ll find one entitled something like “A Different Commodity Investment” from a few years back that explains why.

  4. Jim H.
    April 1, 2013 at 5:09 pm

    One study I’ve seen shows that the correlation between stocks and bond yields inverts from positive to negative, as yields rise through the 5-6% zone. We’re a long way from 5% T-note yields, so the odd (at least to us Seventies mossbacks) post-2008 correlations may persist for awhile.

    It’s sobering to see that Vic Sperandeo’s long-short CTI commodity system, which ought to thrive in periods of low inter-commodity correlations, hasn’t made a new equity high since late 2008. Ironically, CTI never takes short positions in the energy sector, the poster child of the 2H 2008 commodity crash.


    One can surmise that CTI’s ‘never short energy’ rule is an artifact of test data that included the oil shocks of 1973 and 1979. As is so often the case when the historical data series just isn’t long enough (a thousand years works for me), this ‘ayatollah protection’ rule probably hurt performance in 2008, when one could have shorted crude oil to oblivion.

    Oh, well. Laugh all you want, but I’ve got some sector-based stock-picking systems that are pretty robust, and a ten-stock ‘beat the Dow’ system that’s back-tested to 1959. Simple minds, simple answers. David Stockman says we’re doomed; I say ‘conquer the crash.’

    • April 1, 2013 at 10:10 pm

      Ha…when I started in the biz, I worked at a technical analysis firm and we figured out early on that you could come up with really neat results if you simply had a rule that worked out to “don’t be long stocks in October 1987.” So the REAL benchmark was if you could find a rule that did well INCLUDING the crash. It’s hard to do this stuff…which is why there aren’t more billionaire traders!

  5. HP Bunker
    April 2, 2013 at 5:51 pm

    This does seem strange. In the year to date, we essentially have a pattern (if you can call it that) where on days when stocks go down, commodities fall as well, and when stocks go up, well, commodities fall then too. The argument I hear a lot is that it’s the US economy driving the equity market (ours anyway), and since we’re a service economy that requires minimal commodity inputs in order to grow, it makes perfect sense for stocks to rise while commodities fall (of course, we’re also told that manufacturing and housing are (or are about to be) major drivers of growth in the US, but maybe it’s just really small, light products that we make, and tiny, but expensive houses).

    The second part of that argument is that it’s emerging markets (notably China) that consume commodities en masse, and so the decline in commodity prices is presumably related to slowing growth over there. And yet we’re also told that Chinese GDP is growing at close to 8%. I fear that somehow all of this does not add up.

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