Busted Correlations

Just because two items have had some historical relationship doesn’t mean it can’t change.  Betting on reversion to the mean can be extremely dangerous when a paradigm changes.  For a current example, check out this chart from Bespoke on the oil-natural gas ratio:

History is not required to repeat itself!

Source: Bespoke Investment Group   (click to enlarge)

For years and years, it looks like this ratio has been contained in the 5x – 15x range.  In itself, that is a lot of variability.  Now the ratio has blown out to 43!

How do you know when a paradigm is going to change?  That’s the problem—you don’t.  Or you might only know in retrospect when your mean reversion trade completely implodes.

Relative strength investment is relatively resistant to paradigm shifts because it adapts and does not make any assumptions about what the relationship “should” be.  It goes with the trend, until it ends.  When the trend ends, it moves on to something else that is trending strongly.  There is a lot to be said for limiting your assumptions!

2 Responses to Busted Correlations

  1. […] Sometimes markets don’t mean revert.  (Systematic Relative Strength) […]

  2. Steve says:

    In this case the market will automatically mean revert. It make take more time than a trader is willing to wait, but as Nat Gas or Oil becomes relatively cheap, the market will shift to use more of that gas. Obviously at this point we have discovered and mine way more natural gas than we have the capacity to use or transport to other countries. So you might not want to wait for it to happen, but eventually the use and demand for Nat Gas will bring this ratio back towards the mean. (And this graph doesnt look as bad in many other countries. Only in the US is nat gas SOOOOOO cheap.)