Thursday, July 30, 2015

Markets are Interconnected



There are four major markets or asset classes: Stocks, Bonds, Commodities and Currencies.

When it comes to stocks, the US is the largest and most liquid stock market in the world. In the bonds arena, US Treasury Bonds are very important. In commodities, gold, oil and copper are key products. And in the currency space, the US Dollar Index and Euro are kings. I will be doing a series of posts later discussing each asset class in detail.

I feel it’s highly important for investors to understand how these asset classes are one big interconnected web. It is really satisfyingly elegant. As we take a look at the major relationships, there may be a few that will surprise you.


1. Inverse relationship between Bonds and Yields

This is the strongest relationship there is. When a bond matures, you get paid a fixed amount. So the cheaper the bond is to purchase, the more yield you will get. Hence the relationship.


By the way, you can think of the term “yield” as meaning “interest rate.”


2. Inverse relationship between US Dollar Index and Euro

This is the second strongest relationship there is. The US Dollar Index ("USD") is referenced against a weighted sum of foreign currencies. The Euro represents the largest weight at almost 60%.


Note: The US Dollar is also inversely correlated with the Yen, British Pound and Canadian Dollar, but not nearly as tightly as with the Euro. 


3. Inverse relationship between USD and Commodities

Since commodities are priced in USD, it makes sense that these two would have an inverse correlation. 

I have plotted below USD with Gold. A similar relationship exists between USD and oil & copper. This isn’t the tightest correlation, but nonetheless there is one.



4. Direct relationship between US to non-US stocks ratio and USD

This relationship basically says that the relative performance of US stocks to non-US stocks is mainly driven by changes in USD. This makes sense, since when US stocks are doing better than the rest of the world, foreign investors want to invest in the US. This drives up demand for USD.



5. Direct relationship between Real Bonds and Gold

This one might seem very abstract at first, but let’s think about it. First, a couple concepts to review: 
  • The term “real” just means “adjusted for inflation.” If we subtract inflation from an interest rate, we get the real interest rate.
  • Hard assets such as gold and real estate have been shown to keep up with inflation. However, gold doesn't pay any income so its main purpose is simply a store of wealth.

Let's suppose real interest rates are positive. This means interest rates are higher than inflation and we would rather invest our money in bonds than gold. Now suppose real interest rates are negative. This means inflation is higher than interest rates and we would rather invest in gold than in bonds. A drop in real interest rates causes increased demand for gold (and vice versa).

Thus, gold is inversely related to real interest rates. But interest rates are inversely related to bond prices. That means gold is directly related to real bond prices.


6. Direct relationship between Foreign-to-US-stocks Ratio and Mining Stocks

This one may surprise you. But the biggest reason this relationship holds is that compared to the US, foreign markets have a much larger percentage of their GDP coming from the resource sector. The chart below shows how the performance of emerging markets relative to US markets is heavily tied to the gold miners index:



Similarly, the Canadian stock market is heavily commodities-based (40% of the Canada’s TSX Index is based in the resource sector compared to only 20% for the S&P 500). As one would expect, the Canada-to-US-stocks Ratio is also highly correlated with the gold miner's index. 



NOTE: I picked gold miners to compare against here. But I could have used Steel producers or Coal miners as well, as the following chart shows:



7. Direct relationship between Currencies of Resource-Based Countries and Commodities

Similar to relationship #6, the currencies of resource-based countries are highly correlated with commodities such as oil and copper. This makes sense, since when commodities are booming, the GDP of resource-based countries is strong and so foreign investors want to invest in those countries. This increases demand for those countries’ currencies. 



8. Direct relationship between Relative Interest Rates and Currency Exchange Rate

When the interest rates for a country rise, it attracts foreign investors. This causes an increase in demand for that country's currency, which then appreciates in value. The chart below shows the the 2-year Relative Yield (Germany minus US) and how it tracks the Euro.

Source: Jeroen Blokland, Bloomberg

9. Varying relationship between Stocks and Bonds

There is a popular misconception out there that US stocks have a direct relationship with US Treasury yields (and so inverse relationship with bonds). I myself was guilty of believing this for a long time during my market education.

The chart below is from Pimco and shows the annual correlation between US stocks and 10-year Treasury Bonds. From 1927-2012, the correlation between stocks and bonds has ranged from -93% to 86%, changing sign 29 times! It's safe to say there's no reliable relationship here.

 Source: Pimco

Now, that doesn't mean there's no link between stocks and bonds. The Pimco article I linked explains that there are four economic variables that affect the stock-bond relationship: policy rate*, inflation, unemployment and growth. Policy rate refers to monetary policy - when the Central Bank buys/sells bonds to change interest rates (raise rates when economy is strong to curb inflation; lower rates when economy is weak to stimulate it).

Stocks and bonds react in the same direction to policy rate and inflation (eg. if policy rate is dropped, both stocks and bonds go up). But they react in opposite directions to unemployment and growth (eg. when growth is slowing and unemployment is rising, stocks weaken and money flows into bonds as a "flight to safety"). This tug of war between the first two economic variables and second two is why the stock-bond relationship has varied so much.


10. Matrix summary

Here is a handy little matrix I put together to summarize everything I've written about above. Hopefully this shows what I meant about markets being interconnected and elegant.



All the correlations that I've shown so far are true correlations. This means that they can be backed with logical explanations, hold across different periods in time and can be expected to continue holding into the future.

You can use the above matrix to derive new relationships but they won't be as pure. For example: The Yen is inversely related to USD, which is inversely related to gold. That means the Yen is directly related to gold. But we know that gold is also directly related to bonds. Therefore the Yen is directly related to bonds. Now, because we did a lot of conversions, the resulting correlation won’t be very strong as the chart below shows. Furthermore, I cannot give a logical explanation for this one. 



11. How is any of this relevant to Dual Momentum?

This post really dove into the deep end and may leave you scratching your head wondering what any of this has to do with the dual momentum strategy. There are several ways the charts above help Global Equities Momentum (GEM):

  • GEM uses relative momentum to switch between US and non-US stocks. According to relationship #4, we see that GEM therefore protects against, and profits from, fluctuations in the US Dollar. More on this in a future post.
  • If GEM is benefiting from trends in the US dollar, this in turn means GEM exploits commodity cycles to some degree due to relationship #3. For example: from late 2003 to early 2008, GEM was in foreign stocks (during the commodity boom). Then from 2010 to now, it's been in US stocks (during the commodity bust). This concept is further reinforced by relationship #6, which also shows how the performance of foreign stocks relative to US stocks is tied to commodities. 
  • This helps answer the question in my previous blog post: "Should the split of GEM be between developed vs. emerging markets instead of the current US vs. non-US stocks?" The current split means GEM exploits US dollar and commodity cycles. If we changed the split to being developed vs. emerging, then we wouldn't be benefiting as much.
  • GEM uses absolute momentum to switch to bonds when stocks are weak. While stocks and bonds don't have a strong static correlation, we do know that during recessions, stocks often suffer from large drawdowns and there is a flight to bonds during that period (see notes in relationship #9). This is how GEM limits downside risk.

The information in this post is meant to just be another wrench in our toolbox. I also wanted you to get a sense of appreciation for how asset classes are linked together in one way or another. On the surface, markets can seem very noisy and chaotic but the more you study them, the more order you observe.


3 comments:

  1. Excellent insights! Real estate did not figure anywhere. What are your opinions on considering US and Intl. Real Estate?

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    1. Good question.
      - REITs have been highly correlated with equities (eg. Take a look at VNQ vs. SPY).
      - Direct Real Estate (ownership of a physical house) has low correlation with stocks. It reacts positively to inflation, but negatively to interest rates.

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