Why We Need Adaptive Market Indicators

One of the key factors with ODDS Correlation Trader is that it is based on adaptive indicators. The reason is that relationships change over time.

A classic example most of us are familiar with is oil. At times, lower oil prices are good for stocks, as the lower oil price reduces inflation, which improves consumer purchasing power and reduces business expenses. During times like this, oil and stocks are inversely correlated; as oil goes down, stocks go up.

There are, however, periods where the economy is so weak that lower oil prices are a sign that the economy is collapsing. In 2001, we saw this right after the terrorist attacks when travel came to a halt. We saw the same thing last year, as trains, planes, ships and trucks all used far less fuel because the stuff they carried stopped.** When that happened, when people and stuff no longer needed to be someplace else, oil prices collapsed by more than 76%. The collapse in oil occurred at the same stocks collapsed. During this period, oil and stocks were positively correlated.

Then there are other times, when they don’t move consistently together or opposite from one another. The correlation is zero.

Commodities, like oil, and stocks are not the only things that have changing relationships. The chart accompanying this Bloomberg article shows how stocks and the dollar have been correlated over the past year and nine months.

Click image to enlarge

As you can see, right now they are inversely correlated. As the dollar goes down, stocks go up. But during the summer of 2008, it was vastly different. As the crisis was brewing, stocks and the dollar moved in unison. Back then, they were positively correlated. The accompanying article does a pretty good job explaining the fundamentals behind the change in behavior.

That brings up the final point: relationships change. Sometimes, it really is different. As the chart shows, what is ignorant is thinking that this time is not different. In fact, it’s always different. If things didn’t change, if it wasn’t different, then making money would be as easy as identifying a pattern and acting upon that pattern the same way each and every time. But it doesn’t work that way. And the reason is that relationships change. What was once bullish becomes bearish, and then reverts back to bullish. It’s always changing, which is why you have to adapt.

** – Warren Buffett was once asked for his desert island indicator — one set of numbers he would use to gauge the economy. He replied, railroad “freight car loadings”. [Beginning at 2:23 into the video clip]

Comments

[Leftfield:]

Thanks for the excellent information and reminders. Correlations can be revealing when they change. And, the indicators that can't be fudged (much) are more important than ever with the ever-increasing spin from Washington and Wall St. in their figures. Tax receipts are WAY down. Railroad freight car loadings are Buffet's #1 indicator; makes plenty of sense.

Oct 14 09:44 AM