Yesterday we covered the correlation levels between the various traditional asset classes, but today, we’re more interested in the correlation between the markets themselves. While traditional stock brokers were lamenting the rise in correlation among various stocks, CTAs in the managed futures space were becoming frustrated by the way the risk on/risk off plays were impacting correlation among the various futures markets.
As a refresher, correlation simply refers to a numeric connection between two events. The number of people wearing shorts in Chicago, for example, is positively correlated with how warm the temperature is, while the number of people wearing gloves is negatively correlated with how warm the temperature is. The warmer it is, the less people wear gloves and the more people wear shorts. While we can easily see that connection in our minds – seeing such connections between investment returns can often prove difficult. While correlation may be used to analyze market movements, it is important to note that correlation is not the same thing as causation. In other words, just because there is a connection does not mean that one event was caused by another.
In managed futures, managers might specifically select markets for their programs based on a variety of factors. For some, it’s merely based on the levels of liquidity and volatility in a given market. For others, it’s about trading what they’re familiar with. For others still, it’s about these correlation levels between the markets they choose to participate in, whether it’s related to limits in positions that can be taken at a single time, or limits on which markets they can touch to begin with. In a world where trading switches to a risk on/risk off environment, those that have selected their market participation based on correlation levels may find themselves facing a headache.
How much of a headache were these CTAs facing in 2011? We ran the data across 28 different markets for the 2011 as a whole, and while the data was revealing, it wasn’t quite as hard-hitting until held in context, so we also ran the data for January-June of 2011, July-December of 2011, and 2000-2010. If a picture is worth a thousand words, the correlation matrices below are representative of millions of dollars in headaches in the futures markets. The markets are organized by sector, with the blue lines denoting correlation levels within sectors, which you’d typically expect to be moderately high. The correlation levels are shaded according to severity, with strong positive correlations shaded a darker green, strong negative correlation shaded a darker red, and non-correlation shaded with a yellow. Numbers falling in-between these levels are shaded correspondingly. You’ll notice that 2011 definitely saw higher levels of correlation across the board in comparison to the decade prior, but more significantly, that the second half of 2011 witnessed particularly strong levels of correlation between the various markets. What will 2012 hold? Well, the first day of trading would have indicated more of the same, but with a more mixed bag coming out of yesterday’s pit session, we’re hoping we see a far more yellow board at the end of this year.