An Obvious and Important Divergence

As you know, equities have been on a tear in September, and in this market environment, we also know most assets are highly correlated and tend to move together.  At times, it seems like there are only two trades.  There is the "risk on" trade as represented by equities and commodities, and there is the "risk off" trade when bonds outperform.  This is nothing new and something that has been present for a long while.

As an example of this one way trade, we can overlay a chart of copper, as represented by the iPath DJ AIG Copper ETN (symbol: JJC), with the S&P500 (symbol: $INX).  See figure 1 a daily chart with JJC in red and the $INX in blue.  The tight correlations are pretty obvious over the past 12 months.

Figure 1. JJC v. $INX/ daily

However, an important divergence is developing and that is between crude oil and equities.  Crude oil has been in a range for the past month and has not risen like equities or other commodities.  As we can see in figure 2 a daily chart of the United States Oil Fund (symbol: USO) versus the S&P500 (symbol: $INX), USO is lagging.  Over the past year when the risk trade is on, there is talk of improving global growth, which means all commodities and stocks rise together.  That is not the case this month.

Figure 2. USO v. $INX/ daily

So what gives?  Oil fundamentals are such that demand is weak, as the global recovery stalls, and supply is plentiful.  Oil is a good inflation hedge, but according to the Federal Reserve, there is little inflation in the pipeline.  Of course, neither fundamentals nor macro concerns ever really matter until they do, and the high correlations between assets over the past year suggests that these factors matter little anyway.

In my opinion, several things can happen here.  One, oil can catch a bid as traders rotate to this under performing asset.  Pick your reason (improving global growth or inflation) as to why oil will go up, but if it goes up it would suggest a continuation of the risk trade beyond what we have seen this month.  Two, oil can break down, and most likely this will take equities lower.  I believe that is the real message in this divergence.  There is rising risk in rising equity prices as correlations unravel.