Looking at the Correlations

Posted by David Rosenberg

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David Rosenberg, Chief Economist of Gluskin Sheff is one of Canada’s best know analysts. He writes, “Breakfast with Dave” where he tracks economic and market trends and statistics. His daily missive is a favourite of mine because of the quality of David’s analysis. 

In the excerpt below David outlines the correlations between central bank policy and market action. His research concludes that there is an 85% correlation between the Fed action and market moves in the States. (Note: a 100% correlation means that if one variable moves the other variable always move in the same direction. In other words – an 85% correlation is very high.) David outlines what he’s looking for in terms of changes to Federal Reserve policy that would end the bull run in stocks. He also talks the Canadian markets and comes up with some very interesting variables that are correlated to the TSX. – MC


As I mentioned in the recent past, it’s not every year that we get both earnings and revenue growth slowing markedly and the S&P total return well into double digits as was the case in 2012 (and the party has continued well into 2013). That is remarkable and owes to the central bank balance sheet expansion across the planet. The correlation between the Fed balance sheet and the S&P 500 at 87% is more than 4x what it has been in the past and now tops the correlation the market has with earnings! Now that is a new normal.

Going back in time, when the Fed is easing monetary policy (which it still is­ into its sixth year) and the economy is in expansion (about to complete its fourth year), the stock market has an 88% chance of being in a bull phase.

This is contrast to periods when the Fed has inverted the yield curve – during these periods, the market actually is only rising 33% of the time. Or when the economy is in a contraction phase and the yield curve is inverted, the market heads into a bear phase fully 100% of the time.

So for the bear case to come to fruition, or at least have nontrivial odds of occurring, we would need to see either the Fed begin to tighten policy and/or the economy slide back into recession. Now it is unlikely that we will see the yield curve invert given where the funds rate is but when the Fed has been using its balance sheet as the tool to reduce the cost of capital, looking at the curve for clues may be not be so useful this time around. And what gets tie Fed to stop expanding its balance sheet, as it has already told us, dissents notwithstanding, is a move to 6.5% on the jobless rate and 2.5% on the core inflation rate. That will be like watching paint dry. Try years of waiting. So that leaves the recession call contingent on some other shock. A foreign shock? A fiscal shock? An FHA­ related housing shock? A geopolitically-induced oilshock? One thing about  history is that it teaches us that recessions don’t just appear out of thin air .. they are caused by a shock causing the ball in motion to change course.

The way I see it, the Great Recession from 2007 to 2009 resembles to some extent the dramatic pullback in economic activity from 1929 to 1932 (back then there was no social safety net and a third of the population lived on the farm). And the policy-induced rebound in the past four years was very much in the mold of the 1933-36 period – except back then we really did have a V-shaped recovery with average annual GDP growth rates of 10%, not 2%. But both have been equally fragile, and it only took a two-percentage-point of GDP tightening in fiscal policy and a modest withdrawal of monetary stimulus to precipitate a huge renewed down-leg in GDP in 1937-38 (far worse in fact than what we experienced in the 2007-09 period).

Well, this time around we have a similar fiscal contraction. The question is .. will the Fed follow the dissenting hawks on the path of monetary policy stimulus witldrawal? That would probably require a mutiny on the Fed – but look what happened to Volcker in 1986. That is now the principal risk for the economy and the markets and hopefully NOT a non-trivial risk – which is that the Fed follows fiscal policy on the road towards restraint which means – don’t pray so hard for a 6.5% unemployment rate and/or a 2.5% inflation rate. The liquidity implications won’t be so constructive for those who choose to overstay the party from the long side.


Here’s a not-well-advertised fact – Canada’s economy has about an 85% correlation with the U.S. economy and that has not changed much over time. But Canada’s stock market, which traditionally had over a 60% correlation with the U.S. equity market, has whittled down to less than 40% in the past two years (also note that the Canadian stock market only has a 40% correlation with the Canadian economy and this has actually been the case for many years) .

Since China joined the WTO over a decade ago and emerged as a global economic super-power in the process, and the positive secular underpinnings this has provided the resource sector where Canada has triple the U.S. exposure, the correlation between the TSX and the Shanghai index has gone from over 60% to 85% over the course of the past few years. The key here is the impact a Chinese pickup has on the commodity sector because the S&P 500 commands a -30% correlation to the CRB commodity index while the TSX possesses an 88% correlation with that. Something tells me this has something to do with the fact that the direction of Chinese GDP has an 82% correlation with commodity prices, fully 15 percentage points more powerful than tile US economy in this respect.

Finally, we found that there is over a 70% correlation between global GDP growth and the TSX, which is a full 30 percentage points higher than the relationship the index has with Canadian GDP. In other words, the Canadian stock market is a much purer play on what is happening around the world, which is actually what one would expect with a stock market that has nearly 50% of its weighting in the broad resource sector. And it also goes without saying that even if the Canadian economy remains in the doldrums, or even it booms, what matters more to the TSX is the extent to which China proves to be the tide that lifts the Asian boats, or a drag if the recent updrift in inflation reduces the chances of near-term policy stimulus and economic re-acceleration.