It is probably fair to say that basic statistical measures are some of the most powerful mathematical tools in an investor’s arsenal; one such tool is correlation.

The issue with correlations, of course, is that the can be spurious.  Even so, they can also be quite informative when picking through macroeconomic data.  The important thing to note about correlations, is the multivariate nature of markets.  Factors that drive markets over one time period will shift and change, and may no longer apply in future markets.

One interesting example is the post-crisis correlation between US stock indexes and crude oil, shown below.

Global WTI Crude monthly prices (USD) against the S&P500 Index.  Chart and data courtesy of the St. Louis Fed.

You can split crude and equities into three periods roughly in terms of the patterns exhibited on the graphs, the 1980s to 2007 Q4, 2008 Q1 to 2013 Q2, 2013 to present.  The interesting period is the post crisis years until present day.

Crude oil prices converged (and correlated) with US equities during the global financial crisis, the correlation continued until around halfway through 2013, and then the two series diverged.

So what’s going on?

It’s difficult to say with precision, but there are several transmission channels through which this correlation might arise.  Firstly Sovereign Wealth Funds (SWFs) link the two markets.  Sovereign Wealth Funds are a product of resource rich countries- particularly those wealthy in crude oil and gas.  Notable SWFs include Norway’s Government Pension Fund Global, Saudi Arabia’s SAMA, as well as others in China, Hong Kong, Canada, Qatar, Singapore, Abu-Dhabi and Kuwait.  You’ll notice upon reading the list of countries that most countries have historically been oil rich.

The type of behavior that SWFs engage in is similar to that of portfolio manager, but scaled up for an entire geographic region of the world; they seek global yield. Growing oil revenues correspond to profitability for these regions via tax revenues, and thus purchase of investments everywhere (from equities, to fixed income, to property) has quite likely been the case.  SWFs are absolutely enormous- investment titans, and their collective behavior will shift markets.

A handful of global stock indexes  in the immediate post-crisis (QE) era: notice the trend between different indexes.  Up until recently, with the Shanghai composite massively outstripping global indexes, global equities have moved in together.

In addition to the the Federal Reserve, aided by other central banks, has been engaged in Quantitative Easing- an exchange of “non-performing” assets on the balance sheets of commercial banks for liquidity.  This has also buoyed equities in the post crisis era.

So why does this matter?

Well, until 2014, the convergence between crude oil and US equities was quite clear.  In the post 2014 the two have diverged.  The implication of this if the correlation is not spurious (or simply shifting due to underlying fundamentals) is one of the following:

  • US Equities are overvalued relative to crude (and commodities) and are set to fall back down to a reasonable level.
  • Crude Oil is undervalued relative to equities and are set to rise to a reasonable level.
  • Both cases are true and convergence should meet somewhere in the middle.

There have been two major central bank rate changes in two months- the Federal Reserve Rate hike to 0.25% in mid-December which is broadly deflationary and the Japanese rate drop to -0.1% last week which is broadly inflationary (with a promise of further rate drops to come.)   The trend overall seems to be one of ebbing inflation giving way to global deflation- bad for equity prices (in nominal terms at least).

On the other hand we cannot discount the SWFs.  Given slipping crude prices and reduced tax revenues they are likely to be offloading assets which are lower-yield to stay afloat.  This is likely to be cash reserves, commodities, property and so on.  They may even have increased their purchases of equities to seek yield.  This is particularly problematic for them if they have sought yield in the emerging markets with China’s equity markets looking severely overvalued still.  This change in behavior could explain the divergence.

Of course, while equities are likely overvalued, they are far from the most mispriced markets right now.  It pays to keep your eye on the ball- this divergence could continue for far longer than many people anticipate.


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