Friday, September 9, 2011

Europe is the main source of fear



The top chart compares the yield on 10-yr Treasuries (white line) with the level of the Euro Stoxx 50 Index, while the bottom chart compares the same yield on the 10-yr with the level of the S&P 500. 10-yr Treasuries are the beneficiaries of the risks plaguing economies (or the destination of capital flight as the case may be). The correlation between 10-yrs and European stocks is 0.97, while the correlation between 10-yrs and US stocks is 0.89. Both highly correlated, but the fit with European stocks seems pretty rock solid and constant, much more so than with US stocks. Once again, it appears that "it's Europe, stupid" that is the driving force these days.

6 comments:

John said...

Greece is a convenient scapegoat. One that U.S. business leaders and policy makers can't be expected to fix.

Dr William J McKibbin said...

Not just Greece, but Portugal, Spain, Italy, California, New York, and Rhode Island -- the aggregate default risk of any combination of the above is incomprehensible for investors (and taxpayers) -- the "fear" in the marketplace is real and justified until these sovereign economies are made solvent -- for the record, I believe that massive sovereign bond defaults are imminent...

Pragmatic Investor said...

This shows your knowledge of statistics is pretty limited. Correlation on equities should always be on returns, not prices. Having a correlation of 97% between two unrelated financial instruments is next to impossible. I bet you can't explain what 97% correlation really means.

Scott Grannis said...

Re: correlation. I think you are the one that doesn't understand. If prices move up and down together, so do returns. If interest rates move up, bond prices move down. So I am simply comparing the correlation of bond prices (and returns) to equity prices (and returns), which turn out be very highly inversely correlated. It's not often that bonds and stocks move together to tightly.

Pragmatic Investor said...

I am glad you are engaged in this conversation. Comparing prices and returns are two totally separate analysis. By quoting prices AND returns together in your reply again proves you really don't know what you are talking about. Give you an example, stock A's price is 1, 2, 3, 4, 5, 6 on six consecutive days. Stock B's price is 101, 102, 103, 104, 105, 106 on the same six days. If you do price correlation, it is 100%. If you do return correlation, it's totally different. You can NOT base investment decisions on price correlation. Try design a hedging strategy for stock B using stock A. You can NOT, even though their price correlation is 100%. Price correlation does not mean anything.

The Dude said...

Pragmatic Investor is absolutely right. Correlation is not a measure of moving up/down together, it is a measure of moving up/down together LINEARLY.

Since prices DO NOT have a LINEAR relationship with returns (they have an exponential relationship), stock-bond prices and stock-bond returns cannot both be well correlated...if one pair is well correlated then the other pair MUST BE POORLY correlated by definition, even if "bonds and stocks move together tightly."

So you have to pick the right metric...which is the dirty little secret of all statistical analysis (not just correlation): pick the wrong measure and your conclusions will always be wrong even if you do the analysis correctly.