Market Correlation Data Proves Fed Inflation Paradigm Is Bunk

A series of major market correlation charts published yesterday by Bespoke Investment group leads to some interesting conclusions.

For example, the gold-to-S&P500 chart shows that gold was positively-correlated to the stock market from the ’03-’06 period. Then it flipped to neutral to a negative bias (though with some large positive correlation interludes) from ’07 onward.

This makes sense: both gold and the stock market went up, as gold began to anticipate mass financial problems due to proliferating debt, while the stock market dumbly continued upwards on the basis of that very same debt. In ’07, the debt bubble reached exhaustion, the credit market and then stocks collapsed, and gold began to move independently (and mostly upwards, with the stock market moving mostly the other direction).

Somewhat interesting, but not much new there (unless you have been ignoring gold).

A more interesting chart, however, is the first one: the S&P500 vs. oil, reproduced below:

Wow! Look at that positive correlation (around the .8 level) starting in mid ’07!

This coincides with the spread of the financial crisis to the stock market, and oil reacting (probably a little in advance, similar to how gold anticipated the problems stemming from debt growth far in advance of stocks).

But unlike gold, oil has stayed lashed to stocks. Why might this be?

My theory is that the oil market is serving as an “alternative liquidity destination” to the stock market. As a commodity, is viewed as safer than stocks (some of which which have a propensity to suddenly go to zero these days), but it is such a huge market, it has simply become an alternative playground of the same traders that previously were only in stocks (recent looks at speculative participation in the crude market seem to confirm this; though I would argue what they are seeing is mostly “liquidity slosh”, not some sudden, nefarious increase in manipulation). Gold is too small for this (or at least, is viewed as too small), in terms of dollar volume.

At any rate, given this high correlation, combined with the Fed’s admitted goosing of stock prices, we reach an inevitable conclusion: the Fed cannot juice stock prices without similarly boosting oil prices.

This means, for one thing, that it is oxymoronic to omit energy prices and exclusively use “core” CPI for monetary policy decisions. If supporting the stock market is effectively the same thing as raising oil prices, then, at best, these two results will cancel out in terms of overall economic benefit. Naturally, then, measuring progress by a “core” inflation metric that strips out energy will lead to a very destructive sort of “flying blind”.

But since the anti-wealth effect of oil price increases is much greater than the supposed “wealth effect” of the stock market (which doesn’t really exist; it turns out to have been mostly home equity extraction), this also means that the Fed cannot expect to help us out of “recession” by bolstering the stock market. The virtual “tax increase” of higher oil prices to the real economy is simply too much of a massive drag.

Thus, inasmuch as the Fed focuses on marked-to-fantasy asset prices and stock prices to determine how well we are doing — at the expense of energy prices — it will continue to grow increasingly out-of-touch.

This could be an “interesting” (to say the least) recipe for widespread conflict in the new era of economy-driven populist rebellion we are entering.