Some “Overlays”

Quotable

“There is, in short, no great idea that stupidity could not put to its own uses [….] The truth by comparison, has only one appearance and only one path, and is always at a disadvantage.”
― Robert Musil, The Man Without Qualities

Commentary & Analysis

Some “Overlays”

I am painfully aware, through real money loss, correlation is not causation. And often said correlation can break down just at the worst time—when you bet on it. Even more concerning is the belief diversification of portfolios is based on the idea of “non-correlation.”

We have seen many times when hyper irrational behavior substitutes for the normal everyday irrational behavior in the market; it is often the time when supposed “non-correlation” of various assets and sectors becomes correlated, i.e. they all head south at the same time encouraging more selling of that expected “non-correlated” asset class to raise margin funds—the dreaded feedback loop of selling begets selling. Feedback loops were never incorporated into the Capital Asset Pricing Model; well at least it wasn’t when I was in grad school many moons ago. In fact, does anyone other than an academic even waste time with CAPM anymore?

That being said, I have some interesting “overlays” to share. At least I think they are interesting and hope you do to.

Let’s start with good old Dow Theory. To refresh your memory; back in April 29, 2016, on these august pages, I shared the same chart (below) and said:

According to Dow Theory, any new swing high or swing low in one index must be confirmed by similar price action in the other index. I am no Dow Theory expert, to say the least, but the chart below appears to be a non-confirmation signal. The Dow Jones Industrial Average made a fresh swing high (black line), but it was not confirmed by a similar new swing high in the Transports (red line). It suggests a deeper move lower could be in the cards, beyond a standard correction to the bull trend.

To date, the Dow Theory confirmation warning provided itself wrong. The Dow Jones Industrials are up about 500 points since then. Catch up time?

Do yields matter in the currency world anymore? The chart below shows the Australian dollar versus the 2-year benchmark spread between Australia and the United States. Since early July 2016, there has been a big divergence in the price of Aussie and the yield spread. Hmm…Is it time to bet yields still matter?

Interestingly, within a span of only three months, the 21-day correlation between AUD/USD and the 2-year benchmark Aussie-US spread, fell from +98% to -46%. It’s a nice example of how quickly correlation can change.

In the words of the late great Burl Ives, singing Silver:

Silver and gold

Silver and gold

Silver and gold

Ev’ryone wishes

For silver and gold

How do you measure

It’s worth?

Just by the pleasure it

Gives here on Earth…

I suspect some people have other measures for silver and gold—I know my father-in-law (FIL) does.

It is an interesting dynamic, the price action between precious metals and the US dollar. Most of the time there is a negative correlation. But it is not uncommon to see the buck and metals move together for months at a time. Now let’s play a silly game and pretend we do know cause and effect.

I would suggest (read guess) if Janet Yellen & Co. continue to hint that indeed they will hike again in 2016, it should benefit the US dollar because of rising relative yield. And if the US dollar benefits, based on the “overlay” chart below, gold and silver would take a hit.

I am cautiously dollar bullish on the expectation Janet & Co. have become a bit more hawkish because of one key piece of information: The dire consequences the political and media elites warned us about (automatic death of first-born son, locust, World War III, killer frogs, etc.) has not come to pass even though UK voters decided they wanted Brexit.

Of late, UK economic numbers have been decent; and so have Eurozone numbers. Germany has reassured it understands it cannot ice out the UK as it will only hurt its own trade and the EU in general. Prime Minister May is busy lining up new deals now that David Cameron has run off to play with his toys. London-based banks are still in London the last time I checked. And even the sun still rises in the east. Amazing all those over-educated derelicts could be so completely wrong. Well not really amazing. There is a name for it; it’s called the hubris syndrome.

Anyway…to the “overlay” of Gold (green); Silver (black); and US$ Index (blue)…

Have a nice Tuesday.