Recovering Market Losses

By Brad Zigler

Looking at the screen Thursday morning, it's hard to find uptrend lines in anything except the U.S. dollar, the Japanese yen and the short end of the yield curve. Stocks and commodities have both been battered, catching many investors by surprise. Weren't these two markets supposed to be negatively correlated? When one went down, wasn't the other supposed to go up? Wasn't that supposed to even things out in our portfolios?

Yes, commodities and stocks are negatively correlated. In the long term. But in any given time period, the relationship between the two markets may not appear so neat. Look back at market cycles before the current rotation that began in 2001:

Countercycles: Stocks And Commodities

Period	U.S. Stock	Producer Price
	Market Composite	Index (All Commodities)
1898-1920	61%	228%
1920-1929	196%	-38%
1929-1951	-12%	-58%
1951-1965	256%	6%
1965-1981	49%	204%
1981-2001	828%	37%

Generally speaking, commodities zagged when the stock market zigged. Except during the Great Depression and its post-war aftermath.

Seem vaguely familiar? I mean, recessionary flares have been shot off for quite some time. (Need evidence? It's in "Explaining Inflation ... Again.")

Let's jump ahead, though. Let's pretend, just for a moment, that the markets put in a bottom here and poise for recovery. What must commodities do to resume their uptrend?

ICE/NYBOT Continuous Commodity Index (November 2008)

The venerable Commodity Research Bureau Index is now tracked through the Continuous Commodity Index futures traded on the Intercontinental Exchange. November futures topped out at 630 on July 2 and have since fallen to 370, a 41% decline. Securities investors witnessed a contemporaneous 40% depreciation in the analogous GreenHaven Continuous Commodity Index ETF (AMEX: GCC).

If you think the ETF needs a 40% uptick from here to get back to its summer high, you don't know the law of drawdowns. A 40% gain from a base that's 60% cheaper than July's actually means we'd need a 67% gain to clear the deficit.

Doable? Sure. Probable? Well, that's a matter of conjecture. But what if this isn't the bottom? What if commodities grind lower, to a 60% loss from July levels? Then a 150% recovery would be needed to break even. Mounting losses, as you can see in the accompanying table, make recovery geometrically more difficult.

Law Of Drawdowns In Action

Market  Loss	Recovery Required To Break Even
10%	11%
20%	25%
30%	43%
40%	67%
50%	100%
60%	150%
70%	233%
80%	400%
90%	900%

With commodities and stocks swooning, even diversified portfolios are going to have a time of it getting back their market losses. Unless, of course, we can find a way to repeal the law.