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Correlations and Divergence (In Investing)

correlations-and-divergence-(in-investing)

We avoid correlations and divergence both in Forex trading.  The FX market just moves different.

But could we use these things to our advantage in commodities investing?

We certainly can.

Canary In The Coal Mine

Everybody tries to use correlations to get a jump on the future price of a stock or an entire sector.

It’s not super easy to do, because markets can behave irrationally.

Was the move you just saw a break, a divergence if you will, of price, signaling a canary in the coal mine?

Or was it just the market being its irrational self?

I can say this much, the chances of witnessing true divergence go up if two factors are met:

  • The two instruments correlate heavily
  • There was an unexplained drop in price.

You are about to see this very thing occur in this blog post, so keep reading.  I won’t ramble too long.

You Need A Base

We are commodities investors at the 10-Minute Contrarian Podcast.  And we are looking for any edge we can find.

I went ahead and got the free 1-month trial to StockCharts.com to show you some examples of correlations we need to be aware of.

You need a base however.  I am attempting to see which instruments mimic the overall commodities market.

So we need to chart the commodities market first.  I am using the ETN known as iPath Bloomberg Commodities Index Total Return, ticker symbol DJP.  It’s the closest thing to the actual commodities market I could find.

Here is the 15 year chart of this index, since that’s about how long it has been around.  We will be zooming in closer if we need to.

As you can see, commodities languished and didn’t do much from 2016-2020, dropped hard like everything else did in March 2020, and has rebounded big ever since.

Have other commodities followed suit?  Let’s take a look.

Let’s start with copper, and see how it correlates. DJP is always red, so copper is the black line here.  We’ll zoom in to the past 8 years, because who cares what happened before that, amirite?

For the most part, pretty darn good, especially from 2019 on.

For the sake of it, let’s show gold vs DJP.

The scale is different here, so everything is harder to see (my apologies to those on mobile), but if you look closely, you can clearly see…

These two things don’t correlate at all really.  No negative correlation either.  Pretty useless.

What about oil?

Okay, again, scale is officially fucking with us again, but in a much more dramatic way than gold.  But the bottom line is this — these two things correlate quite closely.  Not so much in how dramatic the moves are, but when one goes up, the other does too, and vice versa.

Use the grid for proof of this.  Every quarter, every time one does up or down, the other almost always follows.  I did not expect this, since oil can also be thrown into the “energy” sector as well, and there are so many thing which can move oil independent of commodities, but — here we are.  Data don’t lie.

Now check out platinum:

I had to replace the overall platinum price with an ETF that follows the platinum price, or else we would have had another scaling issue like we had with gold.  So only 3 years worth of data here.

But check it out.  It doesn’t correlate perfectly, but when it ranges, it ranges together.  When it trends, it trends together.  Good correlation overall.

So what the hell has been going on since April 2021?  The platinum price and the commodities price have been going in opposite directions!

The price of commodities overall has been rising, but the price of platinum has inexplicably fallen hard.

This is the divergence we are looking for.  What is giving us a discount, even though is shouldn’t be giving us a discount?

Platinum is.  And for more on why I think this is significant, check out the podcast episode I just did on it.

One More For The Road

Do you like inexplicable divergences?  Sure, we all do.  They don’t happen all that often, so give it to me!

Let’s compare the price of gold with the GDX, the largest gold mining ETF in the world.

5 years ago today:

Gold: $1338.77

GDX: $26.41

Today:

Gold: $1810

GDX: $32.26

Gold miners are volatile.  If you didn’t know, increases in the price of gold has multiplying effects on the profit margins of gold miners.  The GDX should be much, much higher.

Conclusion

There are opportunities everywhere if you know where to look, and you’re willing to wait it out.

We’ll keep them coming, on the blog, and especially on the podcast.

— VP

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