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Like a once happily married couple that ends up getting divorced, correlations in financial markets routinely change and fade over time. Two assets that were in complete symbiosis and moving in lock-step one year can quickly fall out of sync in the next.
We can't control risk assets, only our exposure to them. But because the best indicator of future prices are current ones, the active investor must keep abreast of the market action with the expectation that trends will persist. We're observers first, traders second.
And for well over two years, there's been a regularly demonstrated tendency for risk assets -- from stocks to gold to high-yield bonds -- to rise only when accompanied by a drop in the value of the U.S. dollar.
Risk Up, Dollar Down:
S&P 500 vs. PowerShares DB US Dollar Index Bullish (UUP), June 1, 2010 -December 31, 2010
The relationship was already well defined when we wrote about in the summer of 2009. Back then, as through most of 2010 and 2011, strength in stocks and other risky assets was nearly always accompanied by weakness in the greenback. Over most timeframes in recent years, charts of stocks and other risk assets against the greenback look like virtual mirror images.
Mirror Opposites:
S&P 500 vs. PowerShares DB US Dollar Index Bullish (UUP), January 1, 2011 July 1, 2011
Yet over this past summer, as fears over Europe's debt crisis swelled and risk assets weakened, the relationship began to fade. And judging by recent action, it has now seemingly broken down altogether. Since September, the S&P 500 has risen roughly 6%, but instead of falling, the dollar has actually gained nearly 8%. PowerShares DB US Dollar Index Bullish (UUP), the ETF which tracks the value of the dollar index, hit an 11-month high last week.
A New Dollar Dance:
S&P 500 vs. PowerShares DB US Dollar Index Bullish (UUP), September 1, 2011-January 6, 2012
Much of the index's strength can be attributed to the dramatically weakened euro, which constitutes 58% of the US Dollar Index and has fallen sharply amid Europe's debt crisis. Yet there's other evidence to support the notion that entirely new correlations are brewing. Gold, which has generally been moving along with risk assets since 2010 has also lagged as the dollar has firmed.
As the old adage goes, "one swallow does not make a summer." Just because stocks have been able to rally in the face of a rising dollar over the last few months doesn't insure the prior correlation won't return. Yet it's worth noting that many former leaders known to benefit from a weak dollar like commodities, emerging-market and foreign stocks, have lagged in recent months.
In the past I've often stressed how a new year doesn't necessarily indicate a new market trend or tone. Yet the fact risk assets have been able to muster strength even in the face of a falling dollar provides objective evidence that the game has obviously changed.
Jonathan Hoenig is managing member at Capitalistpig Hedge Fund LLC
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