Correlation Curse

You often hear about investing for diversity.  You also hear that precious metals, soft commodities, emerging market stocks, US Treasuries (or rare stamps, timber lands, or whatever) are good investments because they rally in different markets than ordinary stocks.

During the good times, that’s true, for all those alternatives.  During bad times, it’s mostly true.

During really bad times, it’s not true.

But how can that be?

Shouldn’t a stash of gold coins hugely outperform if paper assets are on their way to zero?  Shouldn’t Treasury bonds be the beneficiaries of a huge bid by investors seeking safety?  Shouldn’t those ag commodities protect you from a worldwide collapse of currencies and capital markets?

Well, sort of.

If you want to outperform the asset class that is doing the worst (epicenter of the meltdown), just being invested in anything else will help you suffer less.  Note that I said less, not avoid suffering.

However, when a meltdown is going on, it’s axiomatic that you really can’t get a bid on the asset class that is tanking.  So what do you do if you own a big slug of that asset, and your counterparties’ margin clerks are on the line demanding cash?

Answer:  You sell what you can.  In other words, selling begets selling, and not just in the class of securities where the problem started.  Often, it’s the classes of investment where people have profits that are the first to go in a panic.  That more or less guarantees that everything else heads south at the same time one big market is getting hammered.

Voila!  That’s correlation.  You may have spent years watching your gold coins or Treasury bonds appreciate on days the stock market dipped, and of course days or even weeks when the stock market rallied and you could just watch.  But when the fit hits the shan, enough of your fellow gold holders and Treasury buffs are looking to raise cash that they begin selling those.

I’ll let you in on one of my favorite sources of information.  Has been for years.

It’s the quarterly Z.1 report from the Fed.

That’s the mother of all debt surveys, and it tells us how much debt there is, be it car loans, muni bonds or private bank “lower floater” derivative bonds.  It’s the source for almost every doom and gloom report you’ll see from the gold-touting sites.

And the story the Z.1 report is telling is not pretty.  Page three of the summary reports tells us the total debt outstanding for various borrower classes.  While perusing the top of the chart to get the column headers in mind, just take notice that with our GDP running between $1.6 and $1.7 trillion back in 1975, domestic financial debt totaled $260 billion (less than 20% of GDP).  For comparison purposes, household and business sectors were each about half of GDP, and Federal debt was just over 25%

Now, scanning down to last quarter, our $14.7 trillion GDP economy is somehow going to pay debt service on $13.5 trillion in household debt, $10.9 trillion in business debt, and $8.2 trillion of Federal debt.  But as outrageous as those are, it’s the financials that take the prize.  They have been shrinking their exposure for the last six quarters (take a bow, taxpayers and savers, for bailing out the banks and giving up your CD interest to rescue them).  But they still have nearly $15 trillion in debt.

So, when a panic downturn comes in any big market, you can bet short odds and win if you bet that at least some domestic financials are holding large chunks of that market, and they are holding it with borrowed money.  Throw in the fact that virtually every financial uses swaps these days to make all their liabilities into short-term debt, and you have frequent rollovers or resets.  Every time that rate resets or that debt rolls over, there’s another opportunity for the holders of that debt to look at the balance sheet, and the assets the financial company holds.  That’s when the financials will be selling assets – any assets.

Welcome to the world of correlation that doesn’t show in the bull market, but can kill you in the bear.


PS I just got back to even in my short-biased long Treasury ETF’s.  I still think when we look back years from now, it will look like 2.5% was basically the low in rates for the 10-year T-Note.  Can Bernanke screw me again in this position? Of course.

But he’ll be just as effective as King Canute was with the tide at the long end of the curve.


22 Responses to Correlation Curse

  1. Bruce B says:


    As you have surely noticed, the pols, financial press and central bankers are all bemoaning the fact that there isn’t lending going on. When analyzing the $33T in debt that you cited above (I’ve seen graphs showing it much higher), it does not appear that more credit in the system is our ticket to a return to prosperity. Maybe that’s simplistic thinking on my part. The Ivy leaguers in charge seem to think it is. (HH – I believe you have an Ivy league education if memory serves. No offense intended).

    Your use of the phrase “giving up our C.D. interest to bail out the bankers,” puts it in perfect perspective. Each time you use that phrase, I do a mini-fist pump. I’m not sure J6PK makes that direct correlation. I hope he does.

    • hhill51 says:

      I don’t mind admitting to the Ivy League years. As Nelson Aldrich explained in his 1980’s book Old Money, the scholarship students attend Harvard and Yale to help the scions of wealth maintain and grow their wealth and position. It’s one place (college) where you’re free to really get to know people, and know you can trust them the rest of your life. Who else is going to be the accountants, lawyers, investment advisors and business managers that will make sure the family wealth is maintained? Yale was close to 50% scholarship students my year.
      I shared an off-campus ratty apartment with a young DuPont (while he was trying being a carpenter instead of an undergraduate for about six months). Great guy, and very fair when he was cut off from the family.
      The issue of marrying within the class, etc. is taken care of by the feeder prep schools, which cost nearly as much as the colleges, so cater to the “right kind.”
      That book came out the same year “Chutzpah” did, and they made a fascinating set of complementary views to take in on one of my rare vacations during that Wall Street time.

  2. J.L. Galbreath says:

    If I understand your article, everything will get hit when there is a collapse! If you are long in mostly gold and silver I would not think you would want to go in to cash since it will most certainly tank the most when the US dollar looses value! I would think now would be a good time to buy hard items that are near the time of replacement and a little food and the where withal that is necessary to maintane control of you assets! It would appear to me that gold/silver and producing land are about the only nearly safe items to own when the results of our elected idiots finally are seen!

    • hhill51 says:

      Your comments echo a private e-mail I got from a friend who deals in coins. In fact, he pointed out that there might not be a numismatic premium in a serious end-of-world scenario. Survivalist mentality, to be sure.
      Along those lines, I’ve seen it suggested that 22 Long cartridges might be the very best “money” since that’s the most common ammo for small game hunting.
      The point of the article was not so much how to deal with the breakdown of civilization as what happens when there is a “crash” in the stock market, muni bonds, or whatever. Purely financial distress, in other words.
      It was partially prompted by the comments that US Treasuries could be beneficiaries in a stock market crash or derivatives meltdown, which would drive the yield on 10-yr Notes down from 2.5% to below 2%, like the JGB.
      I say the flight to safety bid wouldn’t go out past the three year maturity, because the “fixes” likely to be used would work in favor of the borrower — in this case, the government — which is another way of saying we’d come out of it with some kind of debasement of the currency.
      You’re talking about more extreme, and therefore more unlikely, scenarios where all paper assets are simultaneously worthless. Could happen, but I think with this many of us sharing the planet’s surface, some less Malthusian path would develop.

  3. Agent P says:

    “But when the fit hits the shan, enough of your fellow gold holders and Treasury buffs are looking to raise cash that they begin selling those.”


    But for how many more ‘crashes’?

    ‘Raising cash’ assumes that the cash (paper, backed by what?), still has value.

    It is Confidence – with an emphasis on ‘CON’ that will be at issue going forth in any future crash scenario. There is enough action going on by both domestic and foreign entities, to divest themselves of U.S. debt holdings – perhaps slowly, but ever so surely, that a huge run into U.S. denominated ‘cash’ is unlikely, given that the emperor has been summarily disrobed since 2008.

    The jig on $Dollar Supremacy is up – and no one knows this more than the heads of Treasury and Federal Reserve. They’re gunning for agreement in public opinion and sentiment, that we are headed for deflation, so as to allow the necessary breathing room that a devalued dollar would bring to offset our insurmountable existing and future debt obligations.

    There is no other way out, and there is no way the Political Elite – including the Private-for-Profit Federal Reserve are going to allow the social ramifications that a deflationary wash-out would bring, without distorting the financial laws of physics by monetizing what should be allowed to collapse.

    They are going to ratchet-up the stakes in an already high-stakes game of fiscal ‘chicken’, and hope that they can bamboozle the public to accept higher inflation as a consequence of ‘saving us’ from deflationary disaster.

    And I wholeheartedly agree with .22 as a great investment –

  4. Edwardo says:

    At some point, within two years I expect, but possibly much sooner, gold and silver will cease, altogether, to act in concert with the paper PM markets, as the paper markets, which are so fraudulent as to make an Enron exec blush, are well and truly sundered. The LBMA and The Comex are dead men walking and the mere prospect of their ultimate internment will have, among a host of other physical metal friendly developments, a profound impact on the price of gold in all currencies. The last Contango is coming.

    • john east says:

      I held my gold and silver through the 08/09 crash and whilst the ride down from $1000/oz to $700/oz was painful, the recovery to $1200/oz today has been great.

      I don’t expect another panic crash because significant deleveraging has already occured, and SP500 retail investors and high volume trading still have not returned to the markets. A continuing grind sideways to down seems more likely over the next few years, but even if there is another panic, the blood will flow in sovereign debt markets and in the dollar. Predious metals in this environment should see a continuing bid which will more than offset any new deleveraging.

      I hope.

      • hhill51 says:

        My point regarding panic crashes is that when people need to raise money, the only choice they have is to sell what people are buying. That’s almost never the sector with the big problem. I look at the financials in particular, especially with all of them touting their managed commodity accounts, and conclude that the advice to make precious metals or soft commodities a portfolio allocation worthy of more than a few percent puts those investments firmly into the “available for sale” category.

  5. cyn says:

    Hello all,
    hh are you going to share which of those “short-biased long Treasury ETF’s.” you favor?
    My strategy is to sell everything now. Gather enough to retire in Panama or Ecuador.
    Anywhere that quality health care is available, a nice piece of property that has a view of the ocean and I can have a myriad of fruit trees and a teak farm. I need a new life.
    Interesting take re ivy league and all. I did the undergraduate NYC all girls thing. My friends were daughters of the elite of the city, one girl left in tenth grade to marry an Earl in England. Very ruthless world. I am a jewish quadrune, my grandfather had a bonds company, Adler and co. I was told by the grandson of Merrill/Lynch that I was mistress quality, not marrying quality. Went to U of Hawaii. Got as far away as I could. I think it’s time to get as far away as possible again.
    Personally I would like to see a few more of the walls come tumbling down in the WS banking world.

    • hhill51 says:

      I did when I made the call, Cyn, but to repeat, the two I took positions in were TBT and TMV. The logic is that longer dated bonds will still be there to take the depredations of any “remedial action” the politicos take. I’m pretty sure they won’t tell the Tea Partiers that those who collect Social Security today only paid for half or a third of their benefits (and Medicare more like 10%), so they’ll just have to suck it up and stop complaining when their welfare gets cut off. That leaves some combination of rolling it all forward, devaluing the dollar and screwing the current working population, yet again.
      I liked the looks of a 100-acre flower farm I saw for sale down in Hana back in the 80’s. Seemed cheap to me at the time.

  6. Cy Berlowitz says:

    Great post and comments. Sounds as if there’s no port in the storm.
    Still, I’ll take my chances with PMs, oil and other “hard stuff,” with my finger on the trigger.

    Can I flip this over to VF?



    • hhill51 says:

      sure (to posting on VF)…. I didn’t because I don’t want to seem like I’m promoting the blog there. I have just put the mREIT stuff on VF, but this certainly has general investing applicability.
      I’m not saying there’s NO port in the storm, just reminding people that their outperformance in PMs or energy trusts might give them less pain if another liquidity crisis hits. After all, with our banks borrowing more than the GDP, they have their tentacles everywhere, so that means selling everywhere if they have to raise cash again.

  7. Bob Eckhardt says:

    I’m not clear — are you short or long TBT and TMV?

    My own preference is chiefly for gold bullion and cash. I am not a buyer of more gold here but would be a scale-down buyer at, say, $100/ounce price increments. In the meantime, my preference is to build cash not as a store of value, but to facilitate operations in a drop or crash.

    I would be “short” some of the major indices via inverse or double inverse ETFs but my study of the Weimar period is that anything remotely tangible (including shares of companies that probably did not even exist) spiked to the sky, and I believe that the next round of QE has a non-zero probability of producing such a spike.

    • hhill51 says:

      I am long, with near out-of-the-money calls sold on three quarters of the position. Both of those are levered short funds, so I am effectively shorting the Treasuries. The natural compounding problem with these multiplier ETF’s makes them a poor holding unless you can sell some of the volatility. I’ve been doing that fairly successfully with FAZ, keeping a long bias, but selling lots of straddles and strangles.

  8. Jeff Lane says:

    Regarding the Weimar scenario (and Argentina, Zimbabwee, ect) I believe when the initial drops of their currencies occured, the markets tanked. Later they began to rise as it was one of the few choices to protect ones wealth.True or not ? Regarding TBT and FAZ, I have been “selling” puts on any huge drops (like TBT’s 30 level) I plan on adding and rolling them as time goes buy. The reason I’m selling is because there’s no rhyme or reason to this market and getting the timing right (like buying calls) holds more risk. Of course, if TBT goes to 25 then I’m hurt worse.

  9. Edwardo says:

    “My point regarding panic crashes is that when people need to raise money, the only choice they have is to sell what people are buying. ”

    Quite right, Howard, but “they” don’t have it, except in vaporous paper proxies, and even if they did have physical, they wouldn’t have it to sell in anything like what they will need have available to meet demand.

  10. Edwardo says:

    I’d like to suggest that, as per Adam Fergusson’s, When Money Dies, the prospective U.S. experience with hyper-inflation will not evolve in the same manner as occurred in Weimar Germany. I would also suggest reading Gonzalo Lira’s latest two part blog entry regarding how and why hyper-inflation will visit our shores.

  11. TradeProsper says:

    Although I agree with you on Medicare, I disagree on Social Security. After evaluating SS, my take is that it is a stealth regressive tax and certainly not “welfare”. The “entitlement” of SS is that the federal government gives subtandard returns for decades. Even with the current formula of 0% real return, it’s solvent till 2037. Since the financial abyss will hit long before then, it may be a moot point.

    If you compare SS to a “risk free” private annuity (say 10 yr T-bill rates), SS returns are far lower and certainly less than the 1 yr T-bill rate. The difference in return is a stealth tax. Unfortunately, the feds spent the money and didn’t invest. SS is basically flawed. Early in the program it could have been fixed by having a short term tax to cover initial pay-outs and require everyone to invest 6 or 7% in safe instruments (T-bills or possibly GO bonds) for retirement. SS started at 0.5% and was never supposed to exceed 5%. Now we can’t afford to “privatize” since current workers can’t fund both current retirees and their own benefits simultaneously. Public pensions/benefits are closer to welfare than SS, but we don’t hear them talking about that either.


    • hhill51 says:

      I think you’re looking at SS from a static, current “snapshot” point of view as if we were all 65 today and choosing our options.
      Try looking at it from the point of view of those 70-somethings (and older) that were in Washington on Saturday; their COLA’s and the fact that they got much of their early working lives’ credit in the period before the Reagan commission resulted in tripling of the premium paid (1986 Tax Act), Their return is a very serious double-digit percentage that simply isn’t justified by economic reality.
      Check the actuarial costs vs. premium paid on that group of people, and you’ll find that they have a component they paid for, and a component gifted to them.
      That’s my problem with the current BS about “privatization,” as if the actuarial reality does not exist. For SS payments to be owned by each taxpayer and their estate, the overall insurance pool benefit would be lost, so the premium that would have to be required would shoot to the moon. Check out my post a few months ago called “Thank You For Smoking.”

  12. Trent T says:

    Great article! It could be helpful to express the article in terms of purchasing power of bullion vs fiat money; Fiat dollars will lose purchasing power as they are created without limit by government. Bullion may lose some purchasing power relative to things you want to get, but it’s likely to be the ‘cash’ demanded preferentially over fiat for exchange for goods and services– Unless you are talking about returning to a barter economy. All bets off in that case!
    Keep up the good work! Trent T

  13. Thanks for the marvelous posting! I quite enjoyed reading
    it, you’re a great author.I will make certain to bookmark your blog and may come back someday. I want to encourage you to definitely continue your great writing, have a nice holiday weekend!

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: