Asset Appreciation: “Correlations hold Until they Don’t”

Part platitude, part mindless blather, I’m sorry to break out the following trading-floor ‘truism’: “Correlations hold until they don’t.” It’s a sloppy, shorthand way to reminding yourself about the dangers of being complacent. Much of this on-going crisis is the result of complacency developed over years of seemingly inexorable asset appreciation. Market players, regulators, legislators and ratings agencies all were frogs in a pot of water, slowly coming to a boil.

It is our job, as part of the always prescient blog-o-sphere, to be ahead of the curve. Or, at least make some snide comments about our collective lot in life.

To wit, I’m going to start by admitting that I’ve been missing a huge part of the current situation and its effects on the commercial real estate market: the always exciting money supply! I’m also going to admit that I first came across the idea form at article in the Telegraph. Basically, the money supply is shrinking and has been for some time. These folks are throwing terms like “1930’s” around and we have to give a listen. The following chart is from a site called “shadowstats” (the Telegraph sited them as well):

Ignoring the lead-up to the market gyrations of 2008/2009, let’s note the current direction of all three measures of change in money supply: down! True, the data is only through April 2010 so we haven’t seen what things looked like during this most joyous month of May. However, this sovereign crisis has been brewing for a couple months. The world literally needs more dollars. Yes, M1 and M2 are increasing, but they are increasing at a slower and slower pace. This chart is telling me, directionally, that the Fed is being complacent, dogmatic or both.

It’s worth noting two things at this point: 1) the Fed stopped publishing M3 calculations in 2006, and 2) I don’t know anything about the folks at Shadowstats; they could be geniuses or lunatics. On the first note: the Fed says on its own site that cost of calculating M3 outweighed the benefits given that it doesn’t say much that M2 doesn’t. Looking at the above chart, I’m not so sure that’s the case. All you other non-economists out there will have to decide for yourselves.

On note 2): I have no reason to suspect the folks at Shadowstats are anything but completely professional, if not truly insightful. It’s always good, however, to do a bit of homework yourself. So, I went to the Fed web site and pulled some of the data myself. I threw in the monthly closes (GSPC) for the S&P 500, and came up with the following chart:

This brings me back to my opening point regarding correlations. “Correlations hold until they don’t,” is also a way of saying “correlation is relatively easy to establish, but proving causation can be difficult, if not impossible.” So, the chart above shows us how from late 2004 through mid 2007, M2 steadily increases half a point a month while the S&P steadily climbed with few interruptions to speak of; i.e. positive correlation. When things get weird in August of 2007, however, things turn 180 degrees. When money supply is increasing at its highest rate, markets hit their lows; i.e. the Fed steps on the gas and prints money like crazy (negative correlation).

Then comes May. The markets wake up and realize that credit is, perhaps, not so plentiful; especially in Europe. Money supply charts like the one above are less popular because they are volatile and, apparently, subject to vigorous debate. We prefer, therefore, publicly available discounting mechanisms like markets. Specifically, we’ve been watching the TED spread. When you look at the chart (vs. SPXU UltraPro Short S&P500 ProShares), you see there’s not much to debate:

Credit availability is in decline; and I think the pace is accelerating. The last time I posted this chart in early May, the TED spread was at 30bps and now it’s about 45bp! The point: it’s very likely the money supply dropped in May as well, bringing us back to a positive correlation between money supply and asset values. The only way to know the correlations went from 1 to -1 back to 1 was to see them afterward. Tough to trade.

Broader Takeaways:

With this in mind, the Fed may be out of both bullets and credibility. For instance, the Fed recently re-opened emergency swap lines with European central banks’; i.e. making USD available in Europe. In spite of what they say, it doesn’t look like its working. To be fair, someone does point out the solution to the crisis rests firmly in the hand of European officials.

Why? The Fed can flood Europe with USD and still not solve the sovereign debt crisis plaguing the international banking system. Just like rate cuts didn’t help in the US. Someone has to take the bad bonds off European bank balance sheets (nationalization won’t work for an insolvent country). Until then, the markets aren’t sure which international banks are exposed, and the price of dollars will rise (availability will fall).

You can follow along at home by watching the TED Spread, SPXU, SHY (iShares Barclays 1-3 Year Treasury Bond), and CSJ (iShares Barclays 1-3 Year Credit Bond).