May 4, 2011 Guest Commentary by Randy Degner
Note from dshort: Randy Degner is a commodities trader for an oil company in Houston, TX. Here is his snapshot of the relationship between equities and commodities. I’ve thought at length about the bizarre correlation between crude oil and the S&P 500. With equities, oil, precious metals, and other commodities all falling over the last few days, I decided to extend my analysis to the broader commodity market as measured by the S&P Goldman Sachs Commodity Index (GSCI). The GSCI is made up of a basket of commodities covering all major asset groups. Since it’s weighted by trading activity and volatility, a large portion of the index is made up of energy commodities. However, precious and base metals as well as agricultural, meat, and “soft” commodities are also represented. The GSCI is designed to give a portfolio view of commodity price movements. Logic would suggest that the value of commodities should be uncorrelated, or perhaps even NEGATIVELY correlated, to equity prices. But logic would be wrong.
The chart above shows the very strong correlation between commodity and equity prices over the last 18 months. The correlation actually extends back to the precipitous decline in all issue during the 2008 financial melt-down. Over the last 18 months the linkage has been particularly strong, with the r-squared an incredible 88%. Such a relationship is hard to ignore, and reinforces the belief that all markets are being influenced by the same broad macro-economic (or speculative?) trends.
This analysis makes clear that analyzing one particular segment of the financial landscape without considering the fundamentals of other parts of the global financial system is short-sighted and maybe even dangerous. Note for example how the GSCI is now at the lowest level since late March even while (until today) the S&P was very near the highs for the entire move. Could this be a sign of weakness about to emerge in the stock market? It’s too early to say, but it’s a strong possibility. We should know soon enough.