A Quick Word on Correlations

First off, let me clarify a couple things. One, I am not a mathematician, but I do play one on TV . I am, however, a statistics junky, and more so, I am interested in how the masses interpret statistics. I have spent many years watching the markets and the people who watch the markets. I am fascinated with the behavior of the markets and, by extension, the behavior of crowds.

What I have found is that people will try and correlate just about anything with something else to try and find relationships that lead, lag, hedge, or leverage the other. Caution must be used when "finding" correlations. The problem, I think, really, is with the word "correlation," to begin with, as I think most investors are looking not for correlation, but rather for causation.

Many correlations that are discussed or even used as indicators may be complete happenstance and may easily lose any evidence of the high correlation that is observed at that moment in time.

This "phenomenon" is actually talked about frequently. Investment "experts" will talk about how the correlation between certain securities has ceased to exist. The question is – did it ever exist at all? With the effects of the Internet, Twitter, online chat rooms, Facebook, CNBC, Bloomberg, FOX Business and others, data, news, and opinions can spread quite quickly, as can "perceived correlations."

The equity market is especially susceptible to bouts of crowd hysteria, where a "high-profile expert" may begin discussing a correlation and then the news spreads like wildfire, potentially exacerbating a "correlation" that maybe was never a true correlation to begin with, but because of the perceived correlation between the two, traders and investors actually increase the correlation rate.

I do feel some correlations are semi-dependable. One example of this may be that extreme movements in the dollar may cause inverse price action in oil or perhaps gold. Because oil is denominated in U.S. dollars, as the dollar weakens vs. other global currencies, it requires more U.S. dollars to buy oil, therefore the price rises, etc.

The question is, which is the independent which is the dependant. Which is the leader/follower? I would like to think that the more liquid, more fundamental, less manipulate-able issues, such as currency, tend to be independent, whereas smaller issues may tend to be dependant. However, I do not have the research to prove this correct.

What many fail to realize is that this becomes even more difficult when there may another force moving one or both of the securities you are trying to correlate.

Aside from the fact that you might think I am crazy at this point (the worst part is that this is what I dream about at night), hopefully this opened up your eyes a bit and maybe you will take pause next time you want to jump on a correlation trade.

The bottom line is that unless you have studied the correlations extensively and feel absolutely comfortable with them, don’t place all your bets on correlations or expect them to get you out of trouble.