Are Markets 'Decoupling' - And How Would We Know?

The relationship between the United States and the rest of the planet is strained. Our business and political leaders... daily, over piddling affairs that a happily married couple would scarcely take note of. And as to the not-so-piddling matters (for instance, US investment bankers snookering the planet into buying nearly worthless debt and debt-linked securities), the discord is understandable and if anything, more muted than the facts would seem to warrant. Through our lack of judgment regarding or concern over the long-term health of the very financial system the United States largely engineered, we have dragged the global economy into a sickening slump. Would you blame any foreign country or region for their mistrust of US based capital market places? Certainly not. Trust and trust alone unifies the United States with our partners abroad, and that trust has been shaken to the core. In any relationship as frayed as this, there comes a time when divorce, or at least a measured separation, might become inevitable or at least very possible. So the question I have is this: Are we seeing a measured separation between the United States and the rest of the world?

This question could take on virtually limitless dimensions; economic, political, social, cultural. All of these possible dimensions form a seamless web, far too complex to examine responsibly in a short article such as this. So, I will restrict my subject matter to only one dimension – as incomplete as that approach must (of necessity) be. My question is narrow: are the capital markets, at last, showing signs of decoupling?

Why might we care? If we are seeing early signs of decoupling, there are two reasons to care. First, performance chasers will want to deploy assets where performance is expected to be best, so the prospect of outsized returns abroad would drive investment decisions regarding which markets (domestic or international) an investor would wish to deploy capital. Second, decoupling would raise the prospect of greater portfolio diversification through investment allocations weighted domestically and internationally. At the moment, many domestic and international equities markets have been so correlated, some could make a case (in my judgment, wrongly) against allocating portfolio assets between the two. That case would crumble in the face of confirmed decoupling.

One of the most common approaches for measuring decoupling is simply to compare the correlation of returns between, for instance, a domestic equity ETF and an international equity ETF.

I suggest a second approach: a comparison of the technical trading posture of an international and domestic equity index. The main rationale for this second approach is that unlike statistical correlation (based purely on past returns), technical analysis is (or attempts to be) forward looking. And for an investor, forward is the direction to focus the most attention on.

From that perspective, are we seeing evidence of decoupling? Thus far, the answer is not conclusive. To give one example, look at the IShares FTSE/ Xinhua China 25 ETF (FXI). The 50 day simple moving average (or “SMA”) crossed above the 200 day SMA in March of this year, which to many followers of technical analysis amounts to a highly bullish forward looking indicator. Indeed, and true to form, FXI has risen in price steadily since that cross over transpired. And by comparison, look at S&P 500 SPDRs (SPY). There, the 50 day SMA has not yet crossed above the 200 day SMA and so, SPY is technically in a weaker position than FXI. So far, not all that interesting.

But let’s run a thought experiment for a moment. Suppose in the next few days or weeks, the 50 day SMA does surmount the 200 day SMA for SPY. If so, then technically speaking, SPY will be in a comparable technical posture to FXI, and it will be likely, from a technical analyst’s perspective, that both FXI and SPY will likely rise in tandem, undermining the case for decoupling of these two assets going forward. Suppose, on the other hand, that the 50 day SMA for SPY fails to cross over the 200 day SMA. We saw that failure back in July of last year, and following that failure, SPY dove by nearly 50%. If we see a comparable failure of the 50 day SMA to cross the 200 day SMA this time around, traders may very well conclude that based on past performance, SPY is likely to collapse in price (simply because if it did last time, a smart trader will assume it will again, until her or his assumption is disproved).

And in that scenario, what about FXI? Well, FXI might collapse in price as well – suggesting the bullish SMA crossover FXI experienced this past March was a head fake triggered by the higher volatility of this ETF (or some other factor, such as the falling value of the dollar). This outcome would also undermine the case for decoupling.

But alternatively (and here's where it gets interesting), FXI may continue to do what a technical analyst would expect: go up in price simply because a bullish crossover is, well, bullish. If this outcome should play out, then we would have a very strong case for decoupling vis-à-vis FXI and SPY.

As I said, from a technical trading posture, there is no reason to assume decoupling of domestic and international equities markets just yet. But the wait will not be long. We are rapidly getting close to hammer time. SPY, and other broad based domestic equities ETFs are getting close to seeing their 50 day SMA and 200 day SMA converge. This is an inflection point, and it grows closer each day. The technical argument for decoupling will be tested, and it will be tested very soon. Anyone interested in portfolio diversification, or return hogging, should take note.

Disclosures: the Author owns shares in FXI and SPY

Comments

[xxxx:]

who do you think you are fooling cetin. each and every day you create 4 new profiles to populate these boards and spam. go get the professional help you need and leave us alone. post on tech ticker or some other site.


On Jun 11 01:23 PM htr5 wrote:

> up goes the market...this bull cannot be stopped. glad I'm not short
> despite being a bear.
>
> good articles url9.com/y0
>
> This whole 'financial crisis' and 'worst recession since the 30's'
> was in actuality merely a shakeout caused by the collapse of Lehman,
> an is manifested by a sudden, but temporary dip in GDP & profits.
> Things are returning to exactly to how they were before. Nothing
> fundamentally changed. The economies of India, china, Hong Kong,
> Russia, Brazil, Mexico have
> been insulated, in fact.
>
> long MA POT GOOG but still a bear. no plans 2 sell. i am very smart.
>
> good articles url9.com/y0

Jun 11 01:43 PM

[johnthebear:]

Time is short.. even overdue for continuation of the bear downturn, in my opinion. Yep, I am short and the pain is severe at this point. Enjoy your gains while you can, but don't put off taking a profit too long!

Jun 11 03:42 PM

[John Lounsbury:]

Alex - - -

The basic premise of portfolio theory is that various asset classes have correlations that are stable over the allocation period. This condition has blown up in recent years and asset allocation processes have produced far less return and higher volatility than predicted historically.

So, your topic is quite relevant to the problems that asset managers must contend with if they are to survive. Asset allocation seems to have become a monthly thing. It is logical to ask, how is that different from a trading strategy? I think so. I am an investor who feels like a trader. Darwinian theory applies in the market.

Jun 12 05:08 PM

[Alex Trias:]

You're right about Darwin. I represent a number of hedge fund managers - some of whom employ absolute return strategies that worked well several years ago but who now, quite frankly, are having to unwind their funds due, in some cases, or at least in part, to the fact that correlations have gone sort of haywire in various asset markets. You and I would certainly not be the only people asking what the root cause for this "breakdown" is. I'll toss this one out there - when any trade gets too crowded, it stops working. It seems metaphysical to say, but I wonder whether the popularity of pair trading, or other correlation-based trading strategies, has itself been part of the reason why traditionally stable correlations are not working well at the moment. If too many people can make money betting some past statistical correlation will persist, that statistical correlation may just get arbitraged out of existence.

Whatever the root cause may be, the question is how managers ought to respond. I'm increasingly of the view that ideas about a stock's "beta" are outdated - we need a whole new bag of tools. That is the gist of what this article is really about, in fact, although I think I will need to put more thought into your point about the breakdown in correlated asset categories during even relatively long allocation periods. It's a big and important topic, and you've pointed to a slightly different (perhaps more relevant) angle that should be explored further.

THanks for your comment - I always do enjoy reading your responses to my articles as they are typically as insightful as they are concise.

Sincerely,

Alex


On Jun 12 05:08 PM John Lounsbury wrote:

> Alex - - -
>
> The basic premise of portfolio theory is that various asset classes
> have correlations that are stable over the allocation period. This
> condition has blown up in recent years and asset allocation processes
> have produced far less return and higher volatility than predicted
> historically.
>
> So, your topic is quite relevant to the problems that asset managers
> must contend with if they are to survive. Asset allocation seems
> to have become a monthly thing. It is logical to ask, how is that
> different from a trading strategy? I think so. I am an investor
> who feels like a trader. Darwinian theory applies in the market.

Jun 12 09:56 PM