a currency = a yield = a commodity index = a unicorn = energy = healthcare = technology = a rat’s ass

a strange world of what used to be a market, where everything and anything is now correlated positively to everything and anything.

From a guest post @ Zero Hedge:

From John Lohman

"A hedge fund manager/friend of mine recently described forces driving the market as “barely manned scrip cannons.” Unfortunately, I believe it’s a fairly accurate description of the HFT-ETF-Algo driven cluster that used to be a market for financial assets. Individual investors have lost confidence, voted with their feet, and left us with a single asset. It comes with a put option underwritten by the federal government and its value fluctuates in response to barely manned scrip cannons.

"For perspective on how this is impacting macro markets, consider the chart below. It plots the average one year rolling correlation of various markets with the S&P 500 Index. In short, a currency = a yield = a commodity index = a unicorn, etc. Completely different assets with completely different cash flow streams and terminal values are apparently fungible.

"This phenomenon can also be seen within the equity market. Zero Hedge has pointed out the absurdity of the level of implied correlations several times. This chart from Barclays provides some context. As shown, the trailing one month cross-sectional correlation for the largest 1,000 stocks averaged roughly 20% for the last half of the 20th century. The remaining variance in prices would be explained by the fundamental factors within each sector, industry, and firm.

"But in today’s environment, idiosyncratic risk doesn’t exist. As implied correlations asymptotically approach 100%, energy = healthcare = technology = a rat’s ass, etc.

"This is the unfortunate result of markets where governments and central banks try to truncate risk and algos determine marginal prices based on short-term patterns. In the real economy, price signals have become distorted, thus causing capital to be inefficiently allocated. In the financial economy, the environment has become riskier than ever. The farther prices are pushed away from their true underlying value, the greater the adjustment will be. And one thing the algos don’t do - adjust slowly."

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Correlation Between 10-Year Yield and S&P500 Is All-Time High

and it's a good thing, according to Bloomberg.

Fear Feeds Greed With S&P 500 Correlation to Bond Yields Highest on Record (Whitney Kisling and Elizabeth Stanton, 6/27/2010 Bloomberg)

"U.S. stock prices are mirroring government bond yields more than ever, a signal to bulls that shares may be poised to rally.

"The Standard & Poor’s 500 Index and 10-year Treasury rates posted a correlation coefficient of 0.8412 in the 60 trading days through June 16, showing stock prices and bond yields were the most linked in Bloomberg data going back to 1962. The last time the relationship was almost this strong during an economic expansion was at the beginning of the 2002 to 2007 bull market, when the benchmark gauge for U.S. equities doubled.

"Rising correlations show investors are ignoring relative values among industries and assets and reacting to day-to-day signals on the economy, convinced Europe’s debt crisis will spur the second global contraction in three years. Invesco Ltd., Wells Capital Management Inc. and Chemung Canal Trust Co., who together manage $957 billion, say those concerns are overblown and shares will advance as the fastest profit growth since the mid-1990s restores confidence." [The article continues.]

The article notes that the correlation is also strong between the stock market and the commodity market.

Traders have noted that the stock market simply mirrors the forex market recently, particularly currency cross that involves euro (EURUSD and EURJPY mostly, and EURCHF occasionally).

Whereas the Bloomberg article says this strong correlation is a precursor to a strong bull market in the equities, Mark Steele, BMO (Bank of Montreal)'s Quant/Technical Research came to the opposite conclusion with his Focal Points he issued on June 2, titled simply "Go to Cash: Facts and Fiction".

Steele notes the high correlation between different markets- S&P 500 and Asia Dollar Index, Western European default risk and Asian default risk, Asian default risk and crude oil, forex market and default risk, CDS of Bank of America and Spain's Santander almost looking identical, etc., and he senses a danger. A big danger.

In the summary section of the "Plain English" version of the report, Steele says:

"We advocate switching out of equity positions and going to cash. The European sovereign debt crisis appears to be nowhere near over. The global credit environment is worsening. Cost of capital is going up and availability is going down. There are large gaps between where the credit market prices risk and where the equity market is priced. Equity is lagging the deterioration in credit conditions. Moves in currency, equity and commodity markets are mirroring the moves in the credit market. Global growth, in a credit-constrained environment, will slow. Profits will be squeezed by the higher cost of capital."

Who to believe? Clearly many retail investors, particularly after the 'flash crash and dash' of May 6, seem to have decided to stop worrying by yanking their money from the stock market, as seen by the mutual fund flows.

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