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Published by: interconti on Aug 25, 2010
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August 23, 2010
We have talked quite a few times in this space about the poor 2009 conditions which left many managed futures programs with losses last year (read:
“2010 Managed Futures Outlook” 
), and even how some of those conditions carried through to the first quarter of 2010 (read:
“ Are Managed Futures done with the poor 2009 conditions yet?” 
).One of the main reasons for the poor performance, we contend, was the abnormally high correlation (coupling) between commodity markets and stock prices, andbetween commodities themselves. Everything became one big Global Recovery/Recession trade (read:
“ The Global Recovery/Recession Trade ” 
) – with markets adiverse as Cotton, Crude Oil, Gold, and Russell 2000 futures essentially becoming one big “market” which rose when traders believed we were headed for arecovery in world economies, and fell when it seems there’s more global recession ahead.With some big moves up in commodities like Wheat and Coffee over the past few months while equity prices have fallen (both are up around 25% while the S&Phas fallen -11% since the end of April), it is starting to look like stocks and commodities may be coming less correlated, or to borrow a term from economists:‘decoupling’.It may be happening just in time. With nearly three quarters of 2010 behind us and the managed futures indices remaining below their early 2009 highs, the soonerthis pattern ends and we return to an environment where markets start to trade on their own accord based on supply and demand fundamentals, the better as far amost managed futures managers are concerned.
One big “market”? 
Stocks and commodities are supposed to move independently of each other, because they are valued on entirely different premises. Commodities provideeconomic value through being consumed (Sugar in your coffee) or transformed (Crude Oil into Energy), while the value of stocks and bonds lies in the value of theifuture cash flows.Because commodity markets move in reaction to global supply and demand, not the future cash flow of corporations, they are not supposed to be at risk from stocprice declines, liquidity issues, and credit problems which until 2008/2009, nobody understood closely tie together hedge funds, stock, bond, and real estateinvestors.But the credit crisis threw this concept of commodities having little to no correlation with the stock market on its head. That simply wasn’t the case throughout thelast quarter of 2008, most of 2009, and into the first quarter of 2010.Consider the table below which shows the daily correlation between each of the listed markets and the S&P 500 stock index over the listed time frames (1mo, 3mo1yr, 5yrs, and 10yrs). In each market listed, the daily correlation over the past 5 years is higher than over the past 10 years. And the past year is higher than the 5year reading – which all points to steadily climbing correlations.As a refresher, correlation is a statistical figure with values which range between -1.00 and +1.00, meant to show how inter-related two sets of data (in this casemonthly % returns) are. If they have a correlation of 1.00, they are perfectly correlated, meaning when one market rises 1%, the other will do the exact same, andwhen one loses -1%, so will the other. If they are at -1.00, they are exactly opposite; with one making the exact opposite amount the other loses each day, and vicversa. We wondered in a past newsletter if this is a structural shift (a new paradigm) in how stock and commodity markets interact with one another, perhaps based onenergy companies becoming so large that they are a large percentage of the stock indices or something to do with investors adding commodity ETFs to theirportfolios – and at first glance it appears that the trend is continuing.But when we add the past 3 months and past 1 month daily correlations to the table, we start to see a lot more green (negative correlation), painting a differentstory. 
Ignoring the energy markets momentarily, all but one of the tested markets (Copper) is seeing a lower correlation over the past 30 days than it has seen in the pas3 months and 1 year periods. All of the grain markets we tested, Sugar, Cotton, and Cattle and Hogs are, at least in the short term, back to showing their long tercorrelations represented by the 10 year correlation. While this won’t pull down their 1 and 5 year correlations unless it continues for some time, it is a start.Looking at this data another way may give you a better understanding of what correlation/non-correlation and coupled/decoupled actually looks like. In the tablebelow, we calculated the percentage gain or loss for a handful of different markets over three distinct time periods. The first time period is the ‘crash’, starting in Julof 2008 and ending in February 2009 where everything was coupled with significant losses across the board. The next time period spans the bounce in equitymarkets from March 2009 up to the recent April 2010 high point, where some markets started to decouple from stocks. And finally, we have the past 4 monthsduring which the US stock market has fallen back some, but not all markets have followed suit, showing a decoupling again.
Past performance is not necessarily indicative of future results 
While Crude Oil and Copper have remain coupled with stocks throughout all three periods, we can see from the green shading in the table above that several othemarkets have shed their reliance on what the global economy is going to do in favor of their own supply and demand issues.The wheat rally has been attributed to a Russian drought which not only has cut 2010/11 world supply situation, but has also added the possibility that Russianproduction may be short for the 2011/2012 crop year with such a deficiency in soil moisture before seeding begins in the coming months. Any such crop problemsfor the next crop year would draw down world stocks to uncomfortable levels.Coffee prices have been dominated by weather worries as well with crop problems for back to back years in Colombia drawing down high quality coffee suppliesworldwide. The fact that these markets are paying more attention to concerns such as weather and planting issues is a good sign that they will remain decoupledfor a while.
Correlations across commodities:
While covering this topic in the past, we only crunched the data on how correlated different markets were becoming with the stock market (S&P 500) and/or thedollar index (more on that later). We weren’t looking at how the various commodity markets were correlating with one another.But this correlation between markets is a big factor. In fact, it may be even more important than the correlation between commodities and the stock market, givenmany managed futures programs don’t even trade stock indices and that market diversification is a primary risk tool for most managers.Many managed futures programs use diversification across markets as a primary risk tool, risking only a certain percentage on each market, theorizing that theywon’t lose on every market at the same time based on the historical data which shows that all markets
don’t trend and/or reverse trends simultaneously.The more normal course of action, historically, is for some markets to be going up (like Wheat and Coffee recently) while others are going down (like Crude Oil anCopper recently).To see if this is really the case, we took a sampling of eleven commodity markets (Crude Oil, Heating Oil, Natural Gas, Wheat, Corn, Soybeans, Sugar, Cotton,Copper, Live Cattle, and Lean Hogs) and then averaged the 100 cross correlations (Corn with Wheat, Corn with Sugar, Sugar with Wheat, and so on…) each daybetween these 11 markets going back to January of 2000. We found the 10 year cross correlation amongst these eleven markets to be a low 0.18, which is aboutas we would expect and supports the market diversification model used across so many managed futures programs.The test also showed what we knew to be the case, but just hadn’t yet run the numbers on. Much of 2008 and 2009 were significantly different than the 8 yearspreceding them, with the average 30 day cross correlation between these 11 markets spiking up as high as 0.64 in October of 2008 (250% higher than its averageand staying roughly twice as high as its average for most of 2009 into the beginning of 2010. This shows that markets were indeed moving in lockstep with oneanother instead of independently, and that the environment is indeed improving with the cross correlation just recently coming back down to its 10 year average.
US Dollar:
And finally, we have the US Dollar correlation with commodities, which can overrule all other concerns from time to time due to commodities being priced in USDollars. This higher negative correlation than normal between the US Dollar and commodity prices has caused for an odd environment for much of the past 18months where diversification lost much of its effectiveness.In the past, a portfolio long Soybeans, long Gold, long the Euro Currency, long Crude Oil, and long the S&P 500 may have been considered diversified. But 2009changed the game for most of the year, making any long position in an asset priced in US Dollars highly correlated with any other long position. So Gold and CrudOil would rise and fall in tandem depending on what the Dollar did, as would markets as diverse as Soybeans and S&Ps.The further the Dollar declined, the more and more every managed futures portfolio just became one big long trade on everything except the US Dollar (or lookedanother way became one big short trade on the US Dollar).We’re happy to report that this high negative correlation, which reached as high as -0.85 on a rolling 20 day basis between the CRB commodity index and the USDollar Index in late 2009, has continued to trend upwards away from that extreme level, albeit with some sharp moves back down along the way.It hasn’t gone as far as we might expect given some of the data above, but this is mainly due to the CRB being somewhat skewed to energy prices and energiesbeing one of the commodity sectors which has not decoupled from stocks recently.
Whether the high correlation amongst stocks and commodities (and amongst different commodities) is the new normal; or was a temporary result of the need forinvestors of all stripes to sell any asset they had during the fall of 2008 (no pun intended) into 2009 soon to be reversed - remains to be seen.The energies and industrial metals (Copper) are in the structural shift camp, having actually seen an increase in correlation recently and across nearly all timeframes you look at. But the structural shift argument is starting to look weaker and weaker across many other commodity sectors, including the grains, softs, andmeats.These markets are starting to move on their own accord, and that couldn’t be better news for managed futures as an asset class and individual managers who havbeen struggling to get back to their winning ways. One need only look at those managers who have caught the moves in Wheat and Coffee (Dighton Capital, forexample) to see that commodities decoupling from the stock market can be a very good thing.
[Past performance is not necessarily indicative of future results] 
<!--[if !supportLists]-->-
<!--[endif]-->Jeff Malec
 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

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