24 November 2010

Why stock prices and commodities sometimes track one another

In the past few years, many investors have concluded that commodities like oil, corn and gold offer independent returns that can diversify away the risks of stocks. But the correlations between stocks and commodities—the extent to which their prices move together—are in many cases the highest they have been in nearly 30 years...

Some of the linkages between stocks and commodities are looking bizarre. This Thursday, the monthly correlation between sugar futures and the S&P 500 hit 67%, more than 10 times its level just six days earlier, says Howard Simons, strategist at Bianco Research. That is the third time this year that the linkage between sugar and stock prices surged above 60%—much higher than their long-term average of under 20%...

Sugar, says Mr. Simons, is now both an "energy commodity" and a "growth story," since much of the Brazilian crop is used to produce ethanol. That gasoline additive is linked to crude-oil prices, which in turn are sensitive to monetary policy and global economic growth—the same factors driving stock prices...

But there is another, less visible force at work, Mr. Simons says. Algorithmic trading programs, or "algos," automatically buy and sell a wide variety of assets based on mathematical models. An algo doesn't know or care why two assets are moving together; it merely is programmed to recognize that they are doing so. As soon as a computer places bets that such a linkage in prices will persist, other traders—computers and humans alike—tend to take note and follow suit...

"We've gotten to the Frankenstein point where algos are self-programming, and they evolve to chase these relationships," Mr. Simons says. "That's created a sheer wall of money that is forcing other people's behavior into the same pattern."

...And you may have been riding the commodity boom without even realizing it. "It's a common assumption that the average individual investor has zero allocation to commodities," says Matthew Carvalho, director of investment research at Loring Ward, a financial-advisory firm in San Jose, Calif. "But most investors have some indirect exposure to commodities through the stock market."
Further details at The Wall Street Journal.  Some day I ought to write a long post about algorithmic trading programs, the thought of which frankly scares the bejeesus out of me.

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