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Finding Trades Using "Correlational" Research

07/29/2010 12:01 am EST


Andy Waldock

Founder, Commodity & Derivative Advisors

Analyzing the markets requires a combination of quantitative and “correlational” research. It’s easy to track jobless numbers, productivity, crop acreage, or crude oil stocks. These numbers help define the fundamental supply and demand of the price equation. Trading, actual trading, is different from quantitative analysis because we are looking for actionable clues to imminent price movement and what will trigger it. These are the support and resistance numbers, spread ratios like gold to oil, or corn to beans. These are the chart patterns like head and shoulders, bull and bear flags, and reversals that people watch for confirmation of the impact of their quantitative analysis.

Correlational research is an integral part of both fundamental and technical analysis. How many times have you heard the phrase, “Flight to quality?” This phrase is based on money being pulled out of risky assets and placed in safer asset classes like bonds, money markets, or the safe haven of gold. Investors are willing to settle for the bird in the hand rather than chase after the two in the bush. We also see this behavior in the inflation markets. How many times have you heard gold touted as an inflation hedge? Investors concerned with rising interest rates, a falling dollar, or financial panic frequently place a percentage of their portfolio in gold because theoretically, its price should rise with inflation and panic.

Currently, there are several market relationships that are bucking their theoretical correlations. Positive and negative correlations provide clues into market behavior, and when these relationships get out of whack, we should take notice. We can tie the examples mentioned above to two distinct market relationships. The flight to quality is typically measured as money coming out of the stock market and flowing into the bond market. This is visible on charts as a falling stock market and a rising bond prices.

However, my application of flight to quality is based on the relationship between the stock market and the volatility index (VIX). The VIX measures market fear. The more fear there is in the stock market, the more anxious traders should be to pull money out of it. The typical relationship is for the VIX to rise as the stock market falls. Tracking the relationship in this manner means that I don’t have to search out the final destination for funds coming out of the stock market.  It is clear from the chart below that there was far less fear in the stock market when we made the new lows in July than there was when we made the lows of the “flash crash” in early May, or the lows at the end of May when the VIX peaked at 48. The correlational assessment of this relationship suggests that there was far less fear in the market when we made the July lows, and therefore, the stock market outlook may not be totally bearish.

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The second chart illustrates the inflation relationship between US government bonds and the price of gold. Typically, this is an inverse relationship. We see treasury prices fall as gold rallies. This represents investors’ views of future inflation. Gold is purchased as a hedge during inflationary times and sold off in times of economic stability or falling interest rates. Clearly, we are not witnessing the typical relationship between these markets. The bond market is pointing towards lower and lower rates, while the gold market has also enjoyed a considerable rally. An important point in the gold chart comes at the start of the downtrend. The stock market made its most recent low on July 6. This is two days after the gold market began to sell off. In a panic situation, such as the stock market taking out the May lows, one would expect to see the gold market rally. This is especially true in a market that has enjoyed the strength of its current trend and was sitting so near its highs. The stock market’s selloff should have provided the catalyst to move gold ever higher. This is an important divergence. When markets behave abnormally, we must sit up and take notice.

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Unfortunately, I have little to offer as an answer to this riddle. Over the last few months, I’ve seen other relationships break down as well. The US dollar typically moves opposite the oil market. However, oil has remained stagnant in spite of oil’s seasonal strength and a weak dollar since early June. Finally, the commercial traders who I track through the weekly Commitment of Traders (COT) report have shown large and contradictory moves.

Commercial momentum in the gold and stock markets continue to build. These two inversely related markets are continuing to see inflows of capital from far smarter men than myself. Just to complicate matters further, I have also seen a significant build in momentum going out on the term rate structure. This means that big money is flowing from nearby Treasuries and into longer-dated Treasuries. These moves, charts, and relationships should provide for an interesting third quarter. Hold on tight and feel free to share your thoughts.

By Andy Waldock, financial advisor and trader, Commodity & Derivative Advisors

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