Early Morning Musing: Correlations Rising?

By Brad Zigler

Looking at the quote boards this morning, I saw lots of red numbers. Let me stress the word LOTS. Commodities and stocks both woke up on the wrong side of bed today.

Such circumstances get my caffeine-starved brain to thinking. In this case, the thought balloon read: "Hmmm. How often does that happen?" After all, many financial advisors tout the utility of commodities as an asset class with little correlation to equities. A few more mornings like this and you might as well own small-cap value stocks.

Taking pencil to paper, I compared the most readily available target, the Dow Jones-AIG Commodity Index, from its inception to the S&P 500 Composite and found the long-term correlation is -0.93%. That pretty much backs up the financial advisors' contention.

Dow Jones-AIG Commodity Index vs. S&P 500 Composite

But when you look at correlations on a year-by-year basis, you get the sense that the correlation has actually been strengthening recently:

In 2006 and 2007, for the first time since inception, the commodity benchmark earned two back-to-back years of positive - and rising - correlation to equities. Those correlations, to be sure, aren't large. They're just, um, significant. One has to wonder if things might be changing.

Not so coincidentally, commodity index ETFs made their debut in 2006. These portfolios, and the ETNs that followed, opened up new, relatively low-cost portals to commodity exposure for investors. A lot of new money has poured into the commodities asset class relying on a history of low correlation. Only time will tell if that reliance will be rewarded.

Comments

[Geoffrey Lordi:]

Brad,

Interesting article - I appreciate seeing the data. Statistically speaking, however, it is difficult to call a trend, or any expressed significance, with two years of data. Certainly there is the possibility of a defensible trend but two data points - even out of 15-20 - don't reveal enough direction.

In fact, I'm more impressed - in the spirit of your article's theme - by the absolute values of the reversals from '91-'92 (21.52%) and '97-'98 (25.96%). I wonder if, during those years, folks pondered a similar sentiment (that commodities were no longer as decorrelated).

Best,
Geoff L

2008 Jan 17 11:59 AM

[User 142243:]

Brad,
Thanks. I was wondering the same thing myself. I wonder what the ratio is of assets for these ETFs vs open interest. It may help support your claim if the number is significant.

Steve JG

2008 Jan 20 03:08 PM