The following is a guest post by Troy Bombardia.
In the world of investing we have something that is known as correlation. The basic definition of correlation is simple: how do changes in variable X affect changes in variable Y (oh no, more math!)?
Correlation and relations exist in the financial markets. Changes in the price of certain markets (i.e. stocks) will have impacts on prices in other markets (i.e. bonds, currencies, commodities). In this post, I’m going to examine how various markets are related to each other (their correlation).
Why is it important to understand the relationships between various markets? Because if you know how one market is reacting and what relationship other markets have to this market, you can predict what the future price of other markets will be (which equals more profits!).
Note that in the following post, whenever I talk about stocks I’m talking about U.S. stocks. This is because the U.S. stock market is the great barometer of the global stock market. If the U.S. stock market crashes, every other stock market in the world will crash as well. (Think back to the 2008 stock market crash. When the U.S. market crashed, everyone went down as well). I guess that’s just the sway the U.S. economy has over the rest of the world.
U.S. Stocks and the U.S. Dollar
The U.S. dollar and U.S. stock markets have a negative correlation (generally speaking). This means that when the value of the U.S. dollar goes up, the U.S. stock markets either remain flat or fall. The opposite is also true: when the value of the U.S. dollar goes down, the U.S. stock markets go up.
There are 3 reasons for this correlation.
- When the value of the U.S. dollar goes up, companies can export less products (therefore their revenue declines). This is because a more expensive (aka valuable) U.S. dollar means that foreigners need to pay more of their own currency in order to buy American products (thereby making U.S. products more expensive). Thus, corporate revenues tend to decline.
- The U.S. dollar is considered to be the world’s “safety haven”. When the global economy tanks, investors all over the world pour their money into the U.S. dollar. Of course, a consequence of a falling economy is falling stock prices.
- An expensive U.S. dollar means that foreign investors are less likely to invest in U.S. stocks. Nowadays, foreign investors account for a significant portion of overall volume (buying and selling) on U.S. stock exchanges such as the New York Stock Exchange.
U.S. Stocks and Commodities
Contrary to popular belief, stock prices and commodities do not have an obvious correlation. Sometimes stock prices and commodities have a positive correlation (prices rise and fall together), and sometimes these 2 markets have negative correlation (prices move in different directions).
However, there is one factor that determines the CURRENT correlation between U.S. stocks and commodities:
When there exists massive inflation, stock prices and commodity (i.e. oil, gold, silver) prices will have a negative correlation. Inflation cripples stock prices because it means rising corporate costs (and therefore less profits). Remember the 1970s? That was a decade of stagflation (high inflation and a crappy economy).
On the other hand, high inflation is a boon to commodity prices. With the dollar worth less in real terms, commodity prices soar (in nominal terms). You have more paper money chasing after the same amount of physical raw materials, which means that the price of commodities soar.
However, when inflation is low (i.e. below 3% per year), stock prices and commodity prices have a positive correlation (i.e. from 2008 to today). This is because a rising economy means corporations produce more products. In order to produce more products, they need to use more raw materials. When inflation is low, inflation does not affect stock prices or commodity prices (because it’s virtually non-existent!)
U.S. Stocks and Bonds
U.S. bond prices and stocks tend to have a negative correlation. This is going to get a little tricky, so let me explain.
Bond prices are determined by the interest rates that bonds yield. Think of the bond price as ($x) / (interest rate). Therefore, as interest rates rise (the denominator in this equation increases), bond prices fall. The value of the U.S. dollar rises and falls in sync with interest rates.
When our interest rates are high, more foreigners buy U.S. dollars because they can earn more interest here. Thus, when interest rates rise, bonds fall but the U.S. dollar rises. The opposite is also true. When interest rates fall, bonds rise but the U.S. dollar falls.
U.S. Stocks and Other Stock Markets
As I mentioned earlier, the U.S. economy is probably the most important economy in the world (because it’s the largest!). Many companies (stocks) around the world export their products to American consumers. So if foreign stock markets fall, the U.S. stock market often won’t if the U.S. economy is humming along nicely (a good example is the European market crash in 2012 when U.S. stocks held steady).
But if the U.S. stock market crashes, everything around the world crashes as well.
Editor’s Questions: Besides U.S. stocks, what other investments do you hold? Do you consider things like protecting yourself against inflation when making an investment?
About the Author: Thanks for reading everyone! I blog at Ghost For Beginners (click here to see my site). However, it isn’t about investing or trading – just a blogging platform (something similar to WordPress). I might set up a trading blog someday, but at the moment, I’m way too busy. Cheers!