FINANCIAL MARKETS, ESPECIALLY
in an age of computer-driven algorithmic trading, are no longer a solo but a symphony. Assets sometimes follow along with the melody. Oftentimes they wildly follow a tune of their own.
To that end, we've often written about keeping an eye on correlations, or as I like to put it, how markets dance. From my experience, this can best be observed through patient, intraday observation. Stare at the screen long enough and you'll begin to get an understanding of how markets work together. When XYZ rises...does ABC fall or come along for the ride?
From my perch, it appears that the major asset classes are all increasingly correlated. When stocks are rising, bonds and commodities generally appear to get bid as well. When equities fall, as they did last week, so do bonds and many commodities like oil and natural gas.
Birds of a Feather
10-day chart for: Dow (DIA), Bonds (TLT), Natural Gas (UNG), Euro (FXE), Gold (GLD) Oil (USO)
One of the benefits of watching correlations is that they help you to better understand if your portfolio is actually diversified or just disorganized. For example, foreign investing has become widely popular in recent years, and although foreign markets have strongly outperformed domestic stocks, stocks in general are more highly correlated now than ever before.
Last week as stocks dropped, all stocks fell, domestic and international. This is a worthy point, as for many years, one of the main arguments for buying foreign stocks was the benefit of diversification. If shares in the U.S. fell, for example, stocks in Spain or Japan might rise. Now, stocks around the globe move in close synchronicity, meaning that adding a foreign investment to a domestic stock portfolio will increase, rather than diffuse the concentration of that particular asset.
Bonds, at least for the time being, don't appear to offer a solution either. What many believed precipitated last week's stock rout was weakness in the bond market, where the yield on the benchmark 10-year bond has risen from approximately 4.6% in early May to 5.1% today. With the exception of some of the floating-rate preferreds we wrote about a few years back, all bonds fell, from Munis to TIPS to Treasurys. So as stocks were falling, bonds were also getting shellacked as well.
Probably most notable to lay investors is that gold, which is often touted as a "safe haven" refuge from financial assets, appears to correlate with equities surprisingly well. As the Dow was plummeting last week, so were gold and silver prices, with silver dropping from roughly $13.70 an ounce to $13 and gold plummeting $25 to $650 an ounce. A similar scenario played out last March, when a correction in Chinese stocks sent equities world-wide lower: Gold dropped almost 8%.
The other major asset class foreign exchange also had a turbulent week. As major stock and bond markets dropped, the value of the dollar rose sharply, reversing a trend that had been quietly persisting for several months. This aligns with the observation that the dollar tends to be negatively correlated with stocks. When equities rise, especially the large-cap multinationals like McDonald's and Coca-Cola, the value of the dollar tends to fall. When those same stocks drop, as they did last week, the dollar strengthens in many cases quite rapidly.
As a rule, we don't "buy the dips." But if one was compelled to put money to work in light of last week's rout, I think a position in foreign exchange, essentially betting against the U.S. dollar, would be my top choice for new assets. Well-capitalized traders might use the spot or futures markets, while smaller players could opt for the CurrencyShares products we've written about numerous times over the past few months.
The biggest influence in asset allocation should be the price action, and despite the recent jump in the value of the dollar, it's hard to make an objective argument that foreign currency isn't still a comparatively attractive asset class. The Australian and New Zealand dollars, the Chinese yuan, Malaysian ringgit, Canadian loonie and the Colombian peso are just a few on the list of exceedingly strong currencies compared with the U.S. dollar. Even majors such as the euro and British pound, up until last week, were sharply higher as well. It might sound somewhat crazy, but on a purely technical basis, putting your money in Canadian dollars right now seems safer to me than putting it in U.S. Treasury bonds.
And although the weak dollar is more widely discussed than it was a year ago, it's nowhere yet infested the investment herd to the extent you'd believe the dumb money is all on board. From where I sit, that bearish indicator has yet to be triggered.
Think back to the height of the 1990s tech boom or even the more recent bull market in energy, when popular names such as Cisco Systems or Exxon Mobil dominated the portfolios of individual investors. I can distinctly remember individuals asking me 10 years ago why they'd ever need to own anything but Microsoft, Sun Microsystems and JDS Uniphase.
Bull markets are built on doubt, not hope, and when Joe Six Pack is overconfident enough to take big positions in well-known and popular securities, it's likely the big move has already been made. That's not yet happened in FX.
ETF Assets in Billions
Source: State Street Global Advisors, ETF Snapshot May 2007
Indeed, for most people, an exposure in FX is still a relative novelty amounting to no more than 5% of their overall portfolios. Popular financial and general-interest magazines have yet to slap "The Doomed Dollar" on their covers and volumes in products don't yet suggest mass adoption of the theme. For example, despite the fact that the Canadian dollar surged to a 30-year high against the greenback this week, volume in CurrencyShares Canadian Dollar Trust, which holds Canadian dollars, still sits around 14,000 shares a day. For comparison's sake, Apple trades 28 million.
And the currency ETFs, which are likely the product the herd will ultimately embrace for FX exposure, are still an insignificantly small part of the booming capital markets. Out of the 507 listed ETFs, there are only 11 currency products. They hold a total of $2.1 billion dollars out of a total ETF universe of $408 billion.
Predictions don't count, positions do. And even despite the recent jump in the greenback, I believe that 18 to 24 months from now the rapidly declining dollar will have replaced higher energy prices as the nation's gripe-du-jour. Even as markets world-wide become more closely correlated, I still maintain foreign exchange is an integral position notably absent from most portfolios...for now.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC. At the time of writing, Hoenig's fund held positions in many of the securities mentioned.>