An independent professional's take on the latest news and trends in global financial markets

Unusual correlations

I am grateful to Dhaval Joshi of RAB Capital for the observation that something unusual happened in the month of September – bonds, equities and gold all went up together. This is not something that is meant to happen, and rarely does. In fact, according to RAB Capital,┬áthe last time this happened was in the early 1980s.

He comments:

Such a conjunction of asset returns is a rare event in the financial markets. In the 123 calendar quarters since 1980, there have been just 4 other quarters, each in the 1980s, when all three asset classes have gone up by 4% or more. The rarity of this event is because there are virtually no economic or financial scenarios that favour equities, government bonds and gold at the same time – at least under normal circumstances.

The obvious reason for this anomalous turn of events lies in the prospect of further quantitative easing by central banks in the US and UK, allied to monetary stimulus elsewhere – which together are creating massive distortions in asset prices. These are not normal markets and as always when asset prices move in mysterious ways, plausible rationalisations are always at hand. The trick is not to be conned into believing that a distorted market can endure indefinitely.

On the previous occasions that equities, bonds and gold moved up together, at least one of the assets ultimately proved to be mispriced. At the end of 1980, bond prices declined by 20%, while gold plummeted by 40%. In 1983, bond prices fell 10%. And in the middle of 1986, bond prices again dropped by almost 10%. This time too, the assumptions underlying the simultaneous rallies may eventually turn out to be inconsistent with each other.

Note that for equities, both deflation and rising inflation are ultimately enemies. Deflation is a threat to the nominal value of profits, while rising inflation normally means a declining profit share of income. Hence, a portfolio of long dated deep out-of-the money put options on equities, bonds and gold could produce handsome returns. One, or even two, of the options could expire worthless. But for the asset that breaks down, the value of its put option could multiply several times over.

Well, the idea is smart enough. To judge the value of the put option strategy depends on how the relevant options are priced. It is simpler to take a view about which asset class is wrongly priced. Short term, both gold and equities look overbought, so corrections are likely after their strong recent momentum moves. Bonds are the obvious midterm casualty, as they were on the previous occasions.

Written by Jonathan Davis

October 13, 2010 at 1:14 AM