Students are often surprised when I refer to a commodity chart to answer a question on where the stock market is likely to move. What they may not realize is that all markets are related and that if you understand the correlations between the different asset classes, you will have an edge over traders and investors who simply rely on charts of their stock.
The relationships make sense when you think about it. Most traders are aware that bond prices will generally move opposite of equity prices when there is a move to risk averse securities due to insecurity in the economy. But the correlations run much deeper than that; and they can be used to increase your odds of selecting the proper entries and exits.
When you buy stocks it is because you believe that the company and even the economy will be improving. When there is an increase in demand for basic materials, such as copper, this is added confirmation of economic improvement. If the expansion stalls, then there would be a decrease of demand in copper and prices would drop. This often precedes a drop in equity prices as stock investors will react later to economic data that is released.
Commodity prices tend to be more sensitive to changes in the economic environment and can often offer a leading signal for equity traders. At the very least, they may offer a corresponding signal to increase your confidence when entering or exiting a trade. Additionally, knowing the correlation of your investments can help you choose a portfolio that is truly diversified. Why would you want to own two securities that are highly correlated? It would be better to liquidate one and place more money into the investment that is best performing. You will likely earn more and also have less to manage.
So, how can you find correlation? The easiest thing to do is to visually compare stocks and commodities on charts. You can either compare two charts or use an overlay if it is available in your software. There is also a free web resource available to compare certain commodities and even equities.
When you go to that site, you will want to launch the inter-market analyzer tool. This will allow you to compare commodities and even check correlations with stocks and ETFs. The basic comparison is run over the previous six months but you can search for a shorter or longer time as well. Remember, correlations do change with major changes in economic and political environments. You want to make sure you are finding the correlation for the environment you plan to trade, so adjust the time frame as needed.
Notice that there is no longer a high correlation between high grade copper and the S&P 500. The usual correlation is 80-90%. Knowing that this correlation has broken down could be a warning sign for your investments and may assist you in trading decisions for equities in general and stocks in the S&P.
Experiment and see what correlations you can find for your market and stocks. In fact, the majority of our students that become successful traders and investors have knowledge on how to trade multiple asset classes. They trade not only stocks, but futures and forex as well. You will be surprised at how this knowledge can improve your timing and trading ability. Until next time, trade safe and trade well.