diversification no longer a panacea.

[charliebrown]

In this article, the author looks at the correlation between asset classes in the bear market of 00-03 and 07-12 and shows the correlation between all asset classes has closed in the 7-12 period. For example in 00-03, commodities and equities had a correlation of .05 correlation in 07-12 are now at .69

During the 7-12 market the lowest correlation classes with equities is investment grade corporate bonds at .14 and gold at .17.

http://www.zerohedge.com/news/2012-1...ds-are-baloney

[Ghent12]

Re: diversification no longer a panacea.

Why is this so? What is/are the cause(s) of this trend towards correlation? I'll wager that the Federal Reserve Bank plays a role...

[Alvaro Spain]

Re: diversification no longer a panacea.

In this article, the author looks at the correlation between asset classes in the bear market of 00-03 and 07-12 and shows the correlation between all asset classes has closed in the 7-12 period. For example in 00-03, commodities and equities had a correlation of .05 correlation in 07-12 are now at .69

During the 7-12 market the lowest correlation classes with equities is investment grade corporate bonds at .14 and gold at .17.

http://www.zerohedge.com/news/2012-1...ds-are-baloney

I have read somewhere that this is a problem for hedge funds because with high correlations between asset classes you cannot hedge. This explains why, since 2007, the average hedge fund hasn't beaten the market.

Perhaps the problem has to do with how the money is generated. Money that is not earned is misspent or distributed.

[dcarrigg]

Re: diversification no longer a panacea.

Why is this so? What is/are the cause(s) of this trend towards correlation? I'll wager that the Federal Reserve Bank plays a role...

I'd guess rule changes are partially to blame. The numbers are correlated for the periods 2000-03 and 2007-12. Why is it three years in the first case and 5 years in the second? I'm guessing because the numbers in the middle murk up the story (note: I don't have these correlation R^2 values, I'm just positing a theory).

2005 was the primary year for CFTC rule changes. Speculative oil futures vs. industry-related futures went from ~10% of the market by volume to ~50% of the market by volume from '04-'06. So those years would show messy correlations if I'm correct.

But the raw truth of the matter is, when futures markets were limited to some extent to industry players, commodities did not move in lock-step with other markets. Now that the flood of Wall St. cash has swamped commodities markets, in theory, capital will just move in and out of this asset class like it was any other in hopes of generating returns. In return, since oil companies cannot make markets anymore, profit margins for big oil are down, despite price increases.

Put simply, since we broke down all of the rule barriers for where, when, and how much finance can invest in various markets (asset classes), one would expect all asset classes to perform more similarly.

Here are a couple of graphs that show pieces of what I'm on about here in the specific case of one commodity, namely oil:

[Ghent12]

Re: diversification no longer a panacea.

Speculators generally serve to smooth things out for suppliers--it is a very valuable service to all producers because it shifts risks from them onto others who are more capable of handling them. I don't buy that speculation has much of anything to do with oil prices. None of McClatchy's data that you posted relates to supply and demand for oil and/or gasoline. What has global demand been like? What about global supply? Furthermore, what has happened to the global demand for dollars, as well as global supply? The relevant timeframes seem to point the finger straight at Federal Reserve policy rather than anything else. Federal Reserve policy has been to encourage people to chase after every "real" asset they can find, and expecting oil prices to rise as its demand soars while dollar supply also soars seems to be a sure thing.

[dcarrigg]

Re: diversification no longer a panacea.

Speculators generally serve to smooth things out for suppliers--it is a very valuable service to all producers because it shifts risks from them onto others who are more capable of handling them. I don't buy that speculation has much of anything to do with oil prices. None of McClatchy's data that you posted relates to supply and demand for oil and/or gasoline. What has global demand been like? What about global supply? Furthermore, what has happened to the global demand for dollars, as well as global supply? The relevant timeframes seem to point the finger straight at Federal Reserve policy rather than anything else. Federal Reserve policy has been to encourage people to chase after every "real" asset they can find, and expecting oil prices to rise as its demand soars while dollar supply also soars seems to be a sure thing.

To be clear, I wasn't necessarily asking you to buy the theory that speculation drives up oil prices. I put that graph there with the hopes that readers would observe the increase in speculative oil futures contracts. I wish I had a better graph handy that wasn't as preachy...

The point I was trying to make was simply that, as speculation is allowed and increases in different asset classes, one would expect different asset classes to perform similarly, simply because money can move around more quickly and unrestricted to find returns, and this should show a smoothing effect in returns between asset classes.

But if your theory was correct, wouldn't we expect the commodities markets to perform much better than bonds and equities over the '07-'12 period rather than be better correlated and perform more similarly than '00-'03?

Clearly this theory doesn't explain everything. Clearly the Fed's intervention in bond markets and at the discount window has something to do with this.

I just looked at the years in the data (and the years missing), saw the difference in commodity correlations, and thought, "What happend in commodities markets between '03 and '07?"

[lektrode]

Re: diversification no longer a panacea.

but isnt the increased export of refined products one of the main reasons for the uptick in retail prices? (esp as demand has continued to fall, now supposedly at multiyear lows)

dueling headlines over at bloomyville the past few daze show record production and stocks - apparently the switchover from the summer blend is causing the immed problem (read: CA can thank their regulations)

we're at 430-439 upto 450+ on outer islands out here - saw em drop from 370-375 in SLC to the high 360's while there last week....

but guess this is somewhat offtopic, sorry

"What happend in commodities markets between '03 and '07?"

my recollection was that prices seemed to 'moderate' during that period, at least til 2005 or so?
(as i definitely recall getting near zero on savings in '03, which pushed me into buying a house....)
tho i did buy a bunch of rolls of wire in '05 and watched it zoom in price, copper was good to me that year...

[vinoveri]

Re: diversification no longer a panacea.

Speculators generally serve to smooth things out for suppliers--it is a very valuable service to all producers because it shifts risks from them onto others who are more capable of handling them. I don't buy that speculation has much of anything to do with oil prices. None of McClatchy's data that you posted relates to supply and demand for oil and/or gasoline. What has global demand been like? What about global supply? Furthermore, what has happened to the global demand for dollars, as well as global supply? The relevant timeframes seem to point the finger straight at Federal Reserve policy rather than anything else. Federal Reserve policy has been to encourage people to chase after every "real" asset they can find, and expecting oil prices to rise as its demand soars while dollar supply also soars seems to be a sure thing.

The word speculator means different things to different folks.
While I don't understand the intricacies of the futures markets and how it all works, the wild swings in oil prices certainly evidence trading patterns (hedging, speculation, or what have you)- my point is that there appears to be INefficiency in the markets which transmit down stream to consumer in high costs.
If someone wants to explain how, in 2008, the rise of oil to $147/bl and subsequent drop to $35/bl in a matter of months, is a reflection of functioning markets driven by actual supply/demand relationship (vs speculation for instance), please give it a shot.

oil goes from $100 to $147 in months shouuld mean anticipation of a 47% increase in demand or decrease in supply or combination? more likely momentum chasing
oil goes from $147 to $35 in months means dramatic drop in demand increase in supply??..... more likely folks liquidating leveraged positions

Agree with point about Fed culpability

[seobook]

Re: diversification no longer a panacea.

oil goes from $100 to $147 in months shouuld mean anticipation of a 47% increase in demand or decrease in supply or combination? more likely momentum chasing
oil goes from $147 to $35 in months means dramatic drop in demand increase in supply??..... more likely folks liquidating leveraged positions

in terms of the part of the quote I bolded above ... EJ has mentioned in the past how oil price is set at the margin and a million barrels per day or so of imbalance on the supply and demand front (under 2% shift) can cause massive swings in prices.

he also mentioned hedge funds accelerating the pricing push near the peak, but that the structural issues aligned with supply constraints were the main driver for most of the price ramp.

[Ghent12]

Re: diversification no longer a panacea.

To be clear, I wasn't necessarily asking you to buy the theory that speculation drives up oil prices. I put that graph there with the hopes that readers would observe the increase in speculative oil futures contracts. I wish I had a better graph handy that wasn't as preachy...

The point I was trying to make was simply that, as speculation is allowed and increases in different asset classes, one would expect different asset classes to perform similarly, simply because money can move around more quickly and unrestricted to find returns, and this should show a smoothing effect in returns between asset classes.

But if your theory was correct, wouldn't we expect the commodities markets to perform much better than bonds and equities over the '07-'12 period rather than be better correlated and perform more similarly than '00-'03?

Clearly this theory doesn't explain everything. Clearly the Fed's intervention in bond markets and at the discount window has something to do with this.

I just looked at the years in the data (and the years missing), saw the difference in commodity correlations, and thought, "What happend in commodities markets between '03 and '07?"

Good call. Analysis of any specific market requires acknowledging that what you look at is the result of innumerable influences. I just believe that the Fed policy is the prime influencer.

[Ghent12]

Re: diversification no longer a panacea.

The word speculator means different things to different folks.
While I don't understand the intricacies of the futures markets and how it all works, the wild swings in oil prices certainly evidence trading patterns (hedging, speculation, or what have you)- my point is that there appears to be INefficiency in the markets which transmit down stream to consumer in high costs.
If someone wants to explain how, in 2008, the rise of oil to $147/bl and subsequent drop to $35/bl in a matter of months, is a reflection of functioning markets driven by actual supply/demand relationship (vs speculation for instance), please give it a shot.

oil goes from $100 to $147 in months shouuld mean anticipation of a 47% increase in demand or decrease in supply or combination? more likely momentum chasing
oil goes from $147 to $35 in months means dramatic drop in demand increase in supply??..... more likely folks liquidating leveraged positions

Agree with point about Fed culpability

Global oil supply fell sharply in 2nd Quarter 2007, easily explaining a huge spike in prices. A transition from $100 to $147 does not imply a 47% change in either supply or demand, but rather implies some change in supply or demand. The price elasticity of something supplied and demanded is determined empirically after-the-fact, and varies depending upon numerous factors and that is itself another discussion. You can observe the phenomenon of variable price elasticity by comparing cigarettes to apples. As cigarette prices go drastically up, the quantity sold is reduced only slightly, while as the price of apples climbs, people find substitutes such as oranges, bananas, pineapples, or whatever else and therefore the quantity sold of apples will be reduced somewhat significantly, especially when compared to cigarettes.

The plain truth is that speculation, whether it be from industrial users or as some sort of hedge for other institutions, does not play much of a role in increasing prices. Supply and Demand does not get turned on its head just because there are millions of speculators in a market--oil will be bid for based entirely upon supply and demand. While it is true that speculators can have a function in influencing the supply available at any given time, that is all it is--a relatively minor influence. If speculators withhold their oil from the market at a given time, then producers can find ways to sell directly. Speculators can indeed influence price, but their influence is entirely overblown by manic media types. The real cause of huge price fluctuations is that oil, like cigarettes, is extremely addictive. You will not ground your vehicles or cease production just because there is less oil available--you will bid for oil until you simply cannot afford it any more, and only then will you stop demanding it at its price. Likewise, speculators who withhold oil from the market to try to take advantage of favorable market dynamics do so at their own risk, because they may miss the opportunity to sell the oil for gains.

Speculation is a valuable service when the product being produced requires significant capital investment and the returns are significantly variable--hence speculation serves to smooth out agriculture and oil markets, among other products. Speculators stand to make huge gains but also huge losses, all the while serving to reduce the risk to producers such as farmers and oil industry types. They essentially make capital investment in production more appealing.

[don]

Re: diversification no longer a panacea.

Global oil supply fell sharply in 2nd Quarter 2007, easily explaining a huge spike in prices. A transition from $100 to $147 does not imply a 47% change in either supply or demand, but rather implies some change in supply or demand. The price elasticity of something supplied and demanded is determined empirically after-the-fact, and varies depending upon numerous factors and that is itself another discussion. You can observe the phenomenon of variable price elasticity by comparing cigarettes to apples. As cigarette prices go drastically up, the quantity sold is reduced only slightly, while as the price of apples climbs, people find substitutes such as oranges, bananas, pineapples, or whatever else and therefore the quantity sold of apples will be reduced somewhat significantly, especially when compared to cigarettes.

The plain truth is that speculation, whether it be from industrial users or as some sort of hedge for other institutions, does not play much of a role in increasing prices. Supply and Demand does not get turned on its head just because there are millions of speculators in a market--oil will be bid for based entirely upon supply and demand. While it is true that speculators can have a function in influencing the supply available at any given time, that is all it is--a relatively minor influence. If speculators withhold their oil from the market at a given time, then producers can find ways to sell directly. Speculators can indeed influence price, but their influence is entirely overblown by manic media types. The real cause of huge price fluctuations is that oil, like cigarettes, is extremely addictive. You will not ground your vehicles or cease production just because there is less oil available--you will bid for oil until you simply cannot afford it any more, and only then will you stop demanding it at its price. Likewise, speculators who withhold oil from the market to try to take advantage of favorable market dynamics do so at their own risk, because they may miss the opportunity to sell the oil for gains.

Speculation is a valuable service when the product being produced requires significant capital investment and the returns are significantly variable--hence speculation serves to smooth out agriculture and oil markets, among other products. Speculators stand to make huge gains but also huge losses, all the while serving to reduce the risk to producers such as farmers and oil industry types. They essentially make capital investment in production more appealing.

+1 on lucidity alone . . . .

[vinoveri]

Re: diversification no longer a panacea.

....
. A transition from $100 to $147 does not imply a 47% change in either supply or demand, but rather implies some change in supply or demand. The price elasticity of something supplied and demanded is determined empirically after-the-fact, and varies depending upon numerous factors and that is itself another discussion.
....

The plain truth is that speculation, whether it be from industrial users or as some sort of hedge for other institutions, does not play much of a role in increasing prices. Supply and Demand does not get turned on its head just because there are millions of speculators in a market--oil will be bid for based entirely upon supply and demand. While it is true that speculators can have a function in influencing the supply available at any given time, that is all it is--a relatively minor influence. If speculators withhold their oil from the market at a given time, then producers can find ways to sell directly. Speculators can indeed influence price, but their influence is entirely overblown by manic media types.
...
Speculation is a valuable service when the product being produced requires significant capital investment and the returns are significantly variable--hence speculation serves to smooth out agriculture and oil markets, among other products. Speculators stand to make huge gains but also huge losses, all the while serving to reduce the risk to producers such as farmers and oil industry types. They essentially make capital investment in production more appealing.

Can you quantify the impact of speculation on price swings then or explain further the reason for the magnitude of the price swings absent real and equivalent supply/demand swings? Appreciate your cigarrete analogy which is qualitatively effective, but am still not clear as to the quantitative relationship with real suppliers/customers, and their legitimate hedging, and the speculative/finance portion of the market. I get the liquidity angle, but cannot liquidity be part of the problem, and this is where the FEd comes in.

It seems to me your saying that speculation is overall good for everyone b/c markets would not function as well w/o it and further that whatever minor effect the speculators have on price, such is an accetpable price we all pay for the markets as they operate. If this could be quanitified, that would be helpful. What % extra do we pay for a gallon of gas so that the markets can function well?

Do you not agree that broker dealers and other players who are nearest to the Fed's liquidity spigot ( and can borrow money at 10 bps or 100 bps) are not "speculating" in the commodities markets thereby causing prices to rise (speculative carry trade if you will)?

Thanks.

[jk]

Re: diversification no longer a panacea.

the time frame over which correlation is measured makes a big difference. see
http://advisorperspectives.com/dshor...sification.php
as does choice of universe of asset classes
http://advisorperspectives.com/dshor...sification.php

[Andreuccio]

Re: diversification no longer a panacea.

In this article, the author looks at the correlation between asset classes in the bear market of 00-03 and 07-12 and shows the correlation between all asset classes has closed in the 7-12 period. For example in 00-03, commodities and equities had a correlation of .05 correlation in 07-12 are now at .69

During the 7-12 market the lowest correlation classes with equities is investment grade corporate bonds at .14 and gold at .17.

http://www.zerohedge.com/news/2012-1...ds-are-baloney

Couldn't the high correlation among asset classes be easily explained by the wild gyrations since mid-2008 of the common denominator for all asset classes in the U.S.: the dollars in which they are priced?

http://users.zoominternet.net/~fwuth...alForecast.htm

By the way, has anyone else noticed that Finster's been absent for a while?