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Wednesday November 4, 2009 - 14:57:42 GMT
Black Swan Capital - www.blackswantrading.com

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Who leads and who follows…in this correlation

Key News
The euro zone's dominant service sector expanded for the second consecutive month and at its fastest pace in 22 months, led by France. (Reuters)
The interbank cost of borrowing dollars for three months was fixed at a record low for a third straight session on Wednesday. (Reuters)  Fitch downgraded Ireland's long-term rating to 'AA- ' from 'AA+', with a stable outlook. It said the move reflected the severity of the decline in nominal GDP and the exceptional rise in government liabilities.(Reuters)
Japan ex-MOF currency chief Watanabe says the dollar will remain a key global currency as there is no other unit to replace it as a reserve currency. In an interview with Reuters, he says the G20 is unlikely to talk much about the dollar's weakness, which should be discussed by G7 rich nations and China. (Reuters)
 
Quotable 
“You never change things by fighting the existing reality. To change something, build a new model that makes the existing model obsolete.” 
                              Buckminster Fuller
 
FX Trading – Who leads and who follows…
 
I recently downloaded Caesar’s Confessions on to my I-pod so I could listen while doing my strenuous exercise, which consists of a walk around the neighborhood once the US session is finished. Its great stuff, though not exactly easy listening. It’s more like homework. But the depth of the logic and insight into human nature that Caesar display’s is astounding, not to mention his diction and overall writing skills.  
 
To me, it goes to the point that the educated classes were likely a lot more educated in 50 BC then the so-called educated classes today (technological tends to obscure this difference I believe).  While listening to Caesar’s writing’s, one thing stands out the most--human nature hasn’t changed. [Jesse Livermore said the same when he uttered the phrase, “There is nothing new on Wall Street.”]
 
As I was thinking about this, I started thinking about the market—human action drives it now, just as it always has, despite flash trading and reams of algorithms.  Fear, greed, rationality, and irrationality are all on display in the market everyday to varying degrees.  The same is on display on the battlefield, as Caesar so eloquently portrays in his Confessions.  
 
Ultimately those most prepared, which helps create luck, prove to be the winners over time in battle and in trading.  

I imagined Caesar grilling one of the Centurions on why he decided to move troops in a particular direction during the heat of battle, and the Centurion replying something like this:
 
Well Caesar, as you know, there has been a tight correlation between the color of the enemies cavalry horses and their ability to outflank us.  Today we noticed most were on black horses, so that meant we needed to shift our defenses to end of our lines.  
 
Would that make any more sense than saying I sold stocks because the dollar was going up, but later in the day I bought stocks because the dollar was going down; the correlation between the two is very tight.
 
I believe a moderate amount of time in chains to rethink such logic would have been quickly doled out by Caesar had a Centurion utter such a response.  Yet, correlation seems to pass for logic at the moment in the market.  
 
Logic based on pure correlation, based on any sample size you choose is the type of inductive reasoning Karl Popper warned us about (this in an essay in 1959, well before Nassim Taleb became a self-proclaimed superstar of all things logical after ripping off the Black Swan and seeming to often forget it wasn’t his original idea; and for the record, Black Swan Capital was so before said superstar arrived to enlighten all.  Yes, a bit of a chip on the shoulder there indeed…LOL).  
 
Are there logical correlations?  Yes.  But these are usually found in the physical sciences, not in the social variety in which we operate as traders and investors. 
 
It’s not that we can’t trade on such seeming correlations if they help, and they can at times, but when we do, without some modicum of cause and effect or deductive reasoning, can we have any confidence in our ability to know which of the price series in a particular correlation leads or follows?  It seems many seers that have been showing up on CNBC do know exactly who is leading at any given point in time. Scary!   
 
For example, if we said we sold stocks because the dollar was going up, why would the dollar stop going up and stocks stop going down?  Meaning, if the dollar was leading then everyone in the market would likely keep buying dollars and selling stocks in a never-ending feedback loop, I think.  But that doesn’t happen.  It happens for segments of time (fractal maybe), but it can never be the underlying driver because logically it should never end, except when either stocks or the dollar go to zero, depending on who is leading.  
 
So where does this leave us?  I think it should leave us thinking about the fact that at some point this correlation will end for a very good reason.  Thus, we can escape this maddening risk appetite vs. risk aversion world.  For those who are new to this game, and only remember the dollar doing one way—down—as stocks and other asset classes have gone one way—up—it wasn’t always this way.  
 
If you take a look at the dollar bull market (yes there really were a couple of those in the past since 1971) from last 1992 low through 2002, you can see that most of that time stocks (red line) and the dollar index (black line) moved together: [Chart not available in text format.]

The logic behind this relationship was lots of hot money and foreign direct investment wanting to get involved in the tech market boom during those years—short-term portfolio flow targeting quick returns and long-term capital investment buying real assets. Based on current rationales, it is surprising America could have every survived— a weak dollar according to many learned economists of repute is the panacea for US progress—sadly!  But I digress! 
 
Will we use this correlation to our best advantage going forward?  Absolutely, but with the understanding, which comes with betting big on correlations that have quickly broken down in the past and severely dented my rather already small personal wealth,  the stock-dollar correlation could breakdown at any time, and we will only know the reasons with the gift of hindsight.  
 
Unlikely when the gift of hindsight is bestowed upon us all it will deter the savvy traders on the afternoon CNBC trading show—the one with the ugly green background--from glibly declaring they knew it all along.  Sometimes right but never in doubt are they.  I on the other hand am sometimes right but always in doubt. 
 
I think it was Soros who said all traders should be a bit paranoid all the time.  Bingo!
 
Okay, so what is our prediction for a change in correlation?  I laid that out in Monday’s Currency Currents in case you missed it, “A potential premise for a big time surprise.”  The key word in the above sentence is “prediction,” even though I attempted the use of logic and reason.  
 
Here we are, right back to the beginning.  I guess all we can do is the best we can do, and find comfort in one of Mark Douglas’ confessions, I’m paraphrasing:
 
 We don’t have to know what will happen next in the market to make money.
 
I feel better now. The dollar is down and, you guessed it, stocks are higher. And so it goes. 
 
 
Black Swan Capital LLC
www.blackswantrading.com 

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