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Correlation, the only thing that rises in a falling market
October 27, 2008
Being in the Managed Futures business - we can’t get enough of the numbers below (very scary for most, refreshing for a few), and had trouble resisting the urge to put an updated set of Year To Date performance across various asset classes in the newsletter for the third time this month.
Key: All Results above are best estimates off of available data from the following sources Managed Futures = Credit Suisse/Tremont Managed Futures Index, Cash = 3 mo T-Bill rate, Bonds = Vanguard Total Bond Market ETF, Hedge Funds = Credit Suisse/Tremont Hedge Index Commodities – Reuters/CRB Commodity Index, Real Estate = Dow Jones Wilshire Real Estate Securities Index, World Stocks = MCSI World Index, US Stocks = S&P 500 Index
But instead of talking about how managed futures are the place to be during market/economic crisis (which past history suggest is exactly the case – view this newsletter on the topic if you haven’t already: http://www.attaincapital.com/managed_futures_newsletter/298), we want to use this space to talk about a troubling aspect in what’s going on in the other asset classes - the stocks, commodities, real estate, and so on that are all losing money. The troubling aspect isn’t so much that they are all losing money, and it is not even that they are losing so much money. The interesting/scary factor to consider is that they are all losing money at the same time. (See the chart showing market declines since July in the chart of the week section below)
This is troubling because one of the main tenets of modern portfolio theory and basis of most investors various holdings is to diversify amongst asset classes. To see them all losing at the same time and in similarly large amounts kind of throws a wrench in the whole asset diversification model.
But should we be surprised at this? There is an old investment saying we should consider, which says in so many words that “the only thing that rises in a market panic/sell off is correlation.” And while that may seem like just another clever market axiom along the lines of “you’ll run out of money before the market returns to acting rationally”; there is real truth in the saying having to do with correlation rising during times of market stress. (there’s also a lot of truth to the second saying, but we’ll save that for another time)
We have seen this rising correlation amongst asset classes and markets in real time, right before our very eyes these past few months. What started as a real estate down market became a commodity sell off in July, which then turned into a stock market rout in September and October; and along the way hedge funds and even bonds have been hit.
Commodity Prices Moving in Tandem with Stock Prices
The link between the movement in the stock market and commodity prices has become especially pronounced since the beginning of July (and even more so here in October). Take a look at the figures in the table below.
Crude Oil is running at an amazing 0.96 correlation to the S&P 500 in terms of daily price action over the past week. To put this in perspective, a correlation of 1.00 is as high as you can go. At 1.00, the two would be perfectly correlated, rising and falling the same percentage amounts each day. But it’s not just Crude Oil which is seeing this trend – Soybeans were running at an equally insane level of 0.96 over the past week. And indeed commodities in general are seeing the same thing, with the CRB commodity index running at 0.86.
Look at those levels versus the 1 year and 25 year levels. The CRB’s S&P 500 correlaiton is up over 158% versus the month ago period, and +750% over its long term average daily correlation.
Source: Attain Capital
When considering that Crude Oil and Soybeans are supposed to reflect the supply and demand picture for physical commodities, while the stock market is based off the future cash flow projections of component companies – these two should not be nearly perfectly correlated with the stock market. Something strange is indeed going on.
Why the high correlation?
So it looks like the old market saying “the only thing that rises in a falling market is correlation” is true. But that doesn’t tell us why this is happening, and more importantly for readers of this newsletter – what that could mean to their managed futures investments.
First, the why. There are several, several factors contributing to the fact that correlations rise in a falling market. (or in this case – falling markets.) Chief among those is that people are panicking, and start selling not just stocks, but holdings across their portfolios. Some of this is forced selling to meet margin calls, which becomes more and more of a factor the further and further down the market goes – resulting in more and more margin due.
If you’re a hedge fund, some of the selling across asset classes is because you can’t borrow any more money to do a trade in the tight credit conditions – thus have to do the “unthinkable” and sell one of your other holdings to raise cash to do one of your trades. Another hedge fund issue are redemptions, which cause selling of holdings to raise cash to send back to investors.
Whether because of panic, tightened credit, margin calls, or redemptions – all of it points to the need to raise cash. And the only way to raise cash is to sell something. The more you need the cash, the less picky you become on what you’re selling, and eventually you just start selling no matter the asset class – leading to the high correlation.
The specific link between commodities and stock prices lately is not just about raising cash, however. This link has become more pronounced as traders look at all assets as one big bet on the global economy. Traders who think the global economy is heading for trouble are shorting stocks and commodities thinking that 1. there will be less demand for commodities in a global recession/depression as building, consuming, and producing all slow down; and 2. without companies building, consuming, and producing more and more, most companies’ profits will suffer, thus deserving a lower stock price.
What does the High Correlation mean for managed futures ?
Many managed futures investors may be looking at this high correlation in the falling market as a mere curiosity that won’t be affecting their managed futures investment. And who could blame them with the up performance of the managed futures indices in the down market defining managed futures non correlation to the stock markets. But this curiosity does demand some attention, as it brings some unique risks to managed futures programs.
The risk to some managed futures programs is that market diversification may not be enough in times like these. If that is your program’s main source of protection from sharp moves lower (losses in one sector will be offset by gains in other sectors, etc.), the fact that all the different markets are now moving together turns what is supposed to be a small amount of risk on several markets into a large amount of risk on effectively one market (or one trade tied to the global economy).
Programs which are susceptible to this include any CTA which uses market diversification as their primary risk tool, and trade the same model/strategy across many markets in many different sectors.
This is a great tool 95% of the time, but we are now in the 5% of the time when it can become a double edged sword, capable of wiping out large amounts of equity when a highly correlated move across markets as diverse as Lean Hogs and Nasdaq futures happens.
Programs which are better situated to handle this highly correlated environment include discretionary trading programs and programs which use multiple strategy types as a source of diversification. The discretionary nature of CTAs such as Dighton Capital and DMH allow them to initiate day trades instead of longer term positions which would be susceptible to a correlated reversal (Dighton) or sit on the sideline in such conditions until things return to normal levels (DMH). While the strategy type diversification of programs such as APA Modified allow them to utilize different trading methods depending on the environment, such as using counter trend strategies which could profit from a sharp reversal move in all sectors.
In conclusion, there is the very real possibility that we can see a 10% to 20% bounce in the stock market at any point, which in the current highly correlated market environment would likely mean similar moves in markets as diverse as Soybeans and Cotton; and likely cause problems for CTAs diversified amongst market sectors only,
Worried your managed futures program may be at risk of a correlated market bounce in which all the positions currently going in your favor reverse course and cause losses all at once? Give us a call or shoot us an email to see what other sources of diversification your CTA is using (if any) 800.311.1145 or email@example.com
IMPORTANT RISK DISCLOSURE
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Most sectors continued to be under siege last week as traders bet on the possibility that global economic weakness could deepen in the coming months. Most of the pressure stemmed from overseas market weakness due to major companies warning of large cuts for sales forecasts in the coming quarters. These forecasts seemed to deepen ideas that global consumption and purchasing of all products will be reduced greatly from earlier expectations. Nowhere was this more evident than in the Energy sector which led most commodities down. For the week RBOB Gas shed -12.22%, Crude Oil fell -11.17%, Natural Gas lost -8.78% and Heating Oil lost -8.77%
The Metals sector was also punished by recessionary fears and ideas that the current world economics would not support current prices, especially for industrial and building use. Copper -22.72% took the largest hit, followed by Platinum -8.94%, and Gold was not that far behind shedding -7.39%. Silver and Palladium posted nominal losses for the week.
Stock Index futures continued to be pressured by uneasiness in the credit sector despite actions taken by many governments to ease lending anxiety. The sector also had to deal with heavy loses in foreign stock markets which were hit on bad earnings and unwinding of the U.S. Dollar and Japanese Yen carry trades. NASDAQ futures -9.22% led the way followed by the S&P 500 futures -7.34% and Dow futures -5.92%. The small cap sector also ended with steep declines as the Russell was down -10.90% and MidCap lost -5.23%.
Currencies were mixed for the week, although there was strong evidence in the performance that heavy unwinding of the U.S. Dollar and Japanese Yen carry trades took place. The Japanese Yen gained +7.24% and the U.S. Dollar was up +4.84% for the week. The British Pound ended -7.94%, Euro lost -5.85% and the Swiss Franc was down -2.64%. U.S. Rate futures found support from the strength in the U.S. Dollar along with signs that the credit freeze was loosening on a large down tick in the Libor last week. 10-year Notes gained +3.36% and 30-year Bonds ended up +2.93%.
The commodity and food sectors also found pressure from the world financial turmoil that basically has put the brakes on the import/export sector. The fact that the North American grain harvest is underway is also a pressuring agent as new supplies are stuck without a home until the credit facility can function in a more liquid state. The grains ended lower as Wheat was down -8.93%, Corn -7.61% and Soybeans -3.57%. Livestock saw Lean Hogs up +3.86% and Live Cattle down -5.54%. The soft sector was weak as Cotton lost -12.17%, Sugar fell -7.19%, Cocoa was down -6.94% and Coffee shed -6.12%.
The “trick or treat” holiday Halloween arrives this Friday in the US, and for most multi-market CTA’s the month of October has thankfully been more of a “treat” than “trick”. Downward trends in the foreign currencies (stronger US Dollar), energy markets and stock indexes have been especially profitable for those with short positions. Plus, long US Bond and 10 Year Note trades have also been profitable as investors leave the stock market in search of a safe haven for their hard earned assets despite low yields. Heading into the last week of the month, the Attain Portfolio Advisors Modified and Strategic Diversification Programs continue to lead the pack with estimated returns of 17.50% (Modified) and 8.50% (Strategic) respectively. Short stock index, metal and livestock trades as well as long treasury positions continue to produce profits for both programs.
The APA programs aren’t the only multi-market programs that have fared well in October though. Other managers posting gains include Robinson–Langley +6.34% (est), Hoffman Asset +5.54 (est), Long Term Navigator +5.14% (est), Dighton USA +4.57% (est) and Northside Trading +3.43% (est).
Elsewhere the popular Clarke Global Basic and Clarke Global Magnum programs have remained on the sidelines throughout the month due to the high market volatility, while DMH is also near breakeven with small gains of +0.03% for the month.
With volatility showing no sign of slowing down it is no surprise that Option trading has slowed to a grinding halt here in October. The few who have ventured back into the fray are doing so with caution and/or directional trades (i.e out of the money bear put spreads or bull call spreads) looking for an extended down move or even bounce in the market. As not much is likely to change this week here are the estimates for the month of October: ACE Investment Strategists -27%, Ascendant S1 -29%, Cervino Diversified Options -5.37%, Cervino Diversified 2x -13%, Crescent Bay PSI -9.24%, Crescent Bay BVP -8%, FCI -25.5%, LJM Partners -64%, Rathiel -7.9%, Zenith Index -9.24%, and Zenith Diversified -13.23%.
Agriculture and Grain mangers are continuing to hold up despite the wild swings in equities. The star of the week in this sector was Rosetta Capital Management which earned an estimated 10% last week brining their balances back near breakeven for the month. Rosetta has long history of being a strict fundamental/technical trader; while this often means investors must be willing to endure flat and or erratic equity curves their long term equity profile continues to look promising - Rosetta is ahead 18.73% for the year with a drawdown of 9.82% through September (past performance is not necessarily indicative of future performance).
Other Agriculture manger returns for the month include Chicago Capital -3.54%, NDX Abednego -0.3%, and NDX Shadrach -1.99%.
Despite the continuing rise in volatility as global equities continue to plummet, trading activity was extremely limited last week as many systems sat on the sidelines. Overall, swing trading systems outperformed the day traders because of the huge intraday swings.
Beginning with the swing systems, Tzar continues to hold short across the board and even added some open trade equity as stock indices retested the lows made in weeks prior. The NQ is leading the way with the TF (formerly eRL) and ES entering short much later (and at lower prices) but still profitable. Mesa Notes continues to hold long the TY and saw a bounce in open trade equity after getting stopped out of the last long trade as bond markets tumbled despite the downward move in equities (usually inverse relationship between stocks and bonds).
Moving on the day trading programs, Rayo Plus Dax has been on the comeback trail with another stellar performance +$3,463 for the week on four trades. BetaCon 4/1 ESX was the other winner +$1,313 on one short trade from Wednesday. Compass SP and Waugh eRL did not fare as well -$3,470 and -$2,090 respectively.
Finally, in long term trading, the U.S. Dollar continues to rally against the major foreign currencies with the exception of the Yen. Other currencies including Canadian Dollar, Aussie Dollar, Euro and British Pound have been selling off sharply and triggering short entries for most long term programs. Gold also had a sharp turnaround triggering short entries despite the usual tendency for investors to dump money into the safe haven of precious metals in bearish markets.
IMPORTANT RISK DISCLOSURE
Futures based investments are often complex and can carry the risk of substantial losses. They are intended for sophisticated investors and are not suitable for everyone. The ability to withstand losses and to adhere to a particular trading program in spite of trading losses are material points which can adversely affect investor returns.
Past performance is not necessarily indicative of future results. The performance data for the various Commodity Trading Advisor ("CTA") and Managed Forex programs listed above are compiled from various sources, including Barclay Hedge, Attain Capital Management, LLC's ("Attain") own estimates of performance based on account managed by advisors on its books, and reports directly from the advisors. These performance figures should not be relied on independent of the individual advisor's disclosure document, which has important information regarding the method of calculation used, whether or not the performance includes proprietary results, and other important footnotes on the advisor's track record.
The dollar based performance data for the various trading systems listed above represent the actual profits and losses achieved on a single contract basis in client accounts, and are inclusive of a $50 per round turn commission ($30 per e-mini contracts). Except where noted, the gains/losses are for closed out trades. The actual percentage gains/losses experienced by investors will vary depending on many factors, including, but not limited to: starting account balances, market behavior, the duration and extent of investor's participation (whether or not all signals are taken) in the specified system and money management techniques. Because of this, actual percentage gains/losses experienced by investors may be materially different than the percentage gains/losses as presented on this website.
Please read carefully the CFTC required disclaimer regarding hypothetical results below.
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN; IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK OF ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS IN GENERAL OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL WHICH CAN ADVERSELY AFFECT TRADING RESULTS.