Warning: Huge Divergence is Occurring, S&P 500 Could Be Near A Top, Trading Strategy
What are some of the warning signs that you should be aware of? There are many ways to look at and develop a trading strategy, however one that I will point to today is the correlation between the S&P 500 and commodities.
Clearly nothing in investing moves perfectly in tandem. However, it is instructive to look at history when creating a trading strategy and use insights into what's possible in the future.
One commodity that has worried us significantly over the past few months has been copper. Copper is used in many parts of the economy. While some might call it Dr. copper for having a PhD in economic forecasting, we think it might not be that accurate, nevertheless there is some validity to the argument. The movement in copper should play a part in developing one’s trading strategy on a macro level.
It's not just copper that has seen weakness over the past couple months while the S&P 500 has continued its strong move up. As we will show shortly, an index of various commodities has also failed to move up with the S&P 500.
The first chart is a three-year daily chart of copper, the second being a three-year daily chart of the S&P 500. The first things to note are the circled areas up until the end of 2011. It is quite evident that they overlapped very closely, both the S&P 500 and copper prices moved in tandem during this time.
Noting the circled area in 2013, the S&P 500 has continued its strong move up since the lows of November, while copper has turned down significantly. Copper prices are now nearing the lows of October 2011. Note how far higher the S&P 500 is currently versus the lows of October in 2011.
Now, this does not mean that the S&P 500 has to decline to that level. What this does indicate is that this divergence has a high probability of reverting, which could mean that copper and other commodity prices will narrow the spread to the performance of the S&P 500.
This is the Dow Jones-UBS Commodity Index, which is made up of 22 commodities based on futures contracts. Clearly, copper is not the only commodity that is failing to move up along with the S&P 500. This index is made up of energy, agriculture, industrial metals, precious metals, and livestock.
One trading strategy we might entertain is a hedged position, in which a portfolio consists of being short the S&P 500 while being long a basket of commodities. The goal is for this trading strategy is for this spread to narrow.
However, there are many other variables that one has to consider when making any trading decision. In addition to individual risk parameters, the aggressive monetary policy by the Federal Reserve seems to be distorting the S&P 500 while leaving not having the same impact anymore in commodities as it did up until recent times. This appears to be a game changer.
While we are merely indicating that this trading strategy has a certain level of probability for succeeding, the real message is that much of the correlations we've seen over the past couple years are breaking down. Investors need to pay attention over the next few months as we could see increased levels of volatility.
The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.