Monday, November 14, 2011

Which Commodity is Wrong? Part II

In the previous blog post, Rick Vollaro brought to your attention an important divergence currently happening in the market -- the one between crude oil prices on one side and the CRB RIND (raw industrials) and copper on the other. These three indicators are typically regarded both as important global growth barometers and as highly correlated with the stock market. Figure 1 highlights the relative price action of these three series since 10/3/2011, when the S&P 500 formed a short term bottom. Since then, crude oil prices have risen more than 25% while the CRB RIND stayed flat and copper bounced around to end about 7% higher (though it seems to be in the process of rolling over). Meanwhile, the S&P 500 has been stuck in the middle, looking like it's not sure which commodity to follow.

We performed a historical analysis (weekly data available since 1988) to determine historically which, if any, of the above commodity series was most relevant for the stock market. In addition to coincident correlations (relation between movements in two variables at the same time) we also looked at leading correlations (relation between movements in one variable and movements in another variable at some point in the future) up to 8 weeks. Table 1 reports the results. Thanks to the heat map, we can clearly see that both copper and CRB RIND have historically been much more correlated to the S&P 500 than crude oil prices in coincident terms. Moreover, even when a lead is applied, the correlation of copper and CRB RIND to the S&P 500 remains elevated. Table 2 reports the T-statistics of the correlations in Table 1. In other words we are testing whether the results from Table 1 are statistically significant, using a 99% confidence level. When it comes to the T-stat, the higher the better -- specifically, we want it to be higher than a given threshold (the right-most column in Table 2) in order to achieve the desired level of statistical significance. While the T-stats on copper and the CRB RIND are very large and passed the test by an ample margin, only a few of the T-stats on crude oil passed the test and only by a tight margin. Based on these results, copper and the CRB RIND appear to be more reliable barometers of global growth and to correlate better with the stock market than crude oil prices.

Figure 1: Relative Price Action Since 10/3/2011

Table 1: Leading the S&P 500 weekly returns (correlations since 1988)

Table 2: Leading the S&P 500 weekly returns (T-stats since 1988)