Are Stock Correlations (still) profitable in Modern Markets?

...let's start off by looking at interest rates and inflation.

5 minute read

It’s important to understand how different markets are correlated, not just to make it possible to trade the inefficiencies between them, but more-so that you are able to understand the markets as a whole. Having a broad overview of market dynamics, and possessing the ability to make reasonable assumptions as to the way in which particular markets will move should an influential economic event take place, is absolutely essential if you are to become a the Chuck Norris trader I know you aspire to be. The more information you can learn about the markets (especially from this blog) and the way in which money is moved around them, the more chance you have of being able to identify, and take full advantage of any divergence.

Stock Correlations
The US Federal Reserve, and their interest rate policy has a huge bearing on movements within the markets. Keep up to date with the latest economic news is my advice, but it's how you piece that information together that will ultimately determine your success as an investor.

The markets are constantly working their way through cycles, and depending on which stage of a cycle the markets are currently at, the correlations between different instruments can be either more or less pronounced. It’s crucial that you learn to identify how strong the correlation is at any given moment, which involves doing some actual work because, contrary to popular belief, traders don't just sit around on their asses snorting cocaine and cursing at charts all day. The good news is that you can create good opportunities for yourself when you become competent at identifying correlation strength.

 

A useful starting point is to gain a solid understanding of US interest rates, as these play a hugely significant role in today’s economy, so much so, that any news or data sets related to rates can move the markets dramatically (sheeple are fickle, remember this). When the Federal Reserve raise interest rates; what’s referred to as a hawkish move, it is usually a counter-move against increasing inflation figures or forecasts. The theory is that a higher interest rate will increase the cost of borrowing, which in-turn will decrease the demand for goods and services, making businesses reluctant to raise their prices, and therefore have a calming effect on inflation.

 

A raise in US interest rates should strengthen the US Dollar for predominantly two reasons. High interest rates means higher borrowing costs for consumers, which results in less people borrowing, less dollars being printed, and less currency circulating within the economy. The less money in circulation, the higher its value becomes. The second reason is that when US interest rates go up, US banks become an attractive investment proposition for other countries to place their money in, as they will earn more interest on the amounts which they deposit. This causes a higher demand for US currency, and in-turn increases its value. Pretty simple stuff, eh?

 

Stock market indices, such as the S&P500, FTSE and DAX are made up of companies, organizations and institutions which regularly borrow substantial amounts of money from financial institutions (because businesses, as well as consumers are debt junkies too). An increase in interest rates will usually have a negative impact on these markets because of the fact that the entities which make up these indices will now incur higher borrowing costs, and this will ultimately lower the amount of profits that these companies make. This is in addition to the fact that higher rates will cause lower consumer spending power, and the ability for these companies to charge higher prices for their products or services is subdued in this particular economic environment. Power to the people!

"Gold is the most heavily traded commodity in the markets and it is often seen as a safe haven for investors whenever there is any kind of major economic shock or turbulence. Plus it’s shiny and people like shiny things. Gold fever is a real thing folks."

When interest rates have been raised due to inflation, investors are likely to shift more of their portfolio into gold as it represents a more secure location for their capital. There is also the fact that investors only have a limited amount of funds with which to invest, and if money is being moved away from stock market indices during interest rate rises, then it is safe to assume that some of that money will end up being redistributed into gold.

 

The price of oil in the futures markets is denominated in US dollars, so a change in interest rates will also have an impact on the cost of oil per barrel. A stronger dollar puts downward pressure on the price of oil because buyers are able to purchase more oil for their dollar. That being said, the oil market can be a law unto itself and you should proceed to trade it with extreme caution (I'd advise having some You Tube guided meditation at the ready, and at least one pack of Valium on standby). OPEC make periodic regulatory statements with regard to how much oil countries are allowed to produce, and these policies can cause the markets to move significantly, 10% in one day is most certainly not unheard of.

 

The markets are a complicated puzzle, like a Rubik's cube with no square the same color, and you will need to acquire a comprehensive perspective of both the medium and long-term economic outlook in order to put the pieces together. If you can achieve this with reasonable understanding, and adopt a logical approach with regard to why certain events might trigger a rally or a sell-off in a particular market, then you will stand far greater odds of being successful in the financial markets.

 

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