The Ring of FireEarthquakes are an interesting analogy for how markets sometimes move. Correlations may be stable for a time, as they have been for the past couple of months, but then a sudden tectonic shift can either break a given correlation or maintain it but cause a sudden shift in differential between the correlated items. Case in point, Monday the first of March. I have ¾ of my trading assets in USD (alas), and have to suffer the constant currency hit when oil and to a lesser extent, other commodities and equity markets go up. It’s been like clockwork for quite some time. On Monday, oil and other commodities were down significantly, the USD up. The Canadian dollar should have been down as well (mitigating the other declines, to my advantage) but instead went roaring the other way by over a full cent — the reason being an upbeat GDP report from Canada. Needless to say I took a relatively outsized hit in CAD terms that day. The next day the correlation returned to “normal”, but the Canadian dollar had shifted to a higher relative position against the US dollar – a sudden tectonic shift in differential as it were. (A similar analogy from physics is how particles jump from one quantum energy level to another without any smooth transition in between).

The markets then have their own “ring of fire”. Earnings announcements, takeovers, devaluations, surprise government rate and policy decisions, crop reports. These are the risks of living in sunny market climes. They can be more or less managed if you build your portfolios to “code”, but once in a while such an event (e.g., the subprime crisis) can spawn a killer tsunami (the 2007-2009 bear market/“Great Recession”) and severely damage even a well-constructed portfolio. And the portfolios built by crooked contractors that cut corners (Madoff); well those are completely shattered and washed out to sea.

What’s your portfolio building code? And where’s your high ground?

Henry Gifford comments:

Building codes follow Bacon's law, both mandatory codes and voluntary standards.

The changes are partly in response to lobbying by manufacturers of products, partly in response to new technologies becoming available, partly due to changing politics/wealth levels/societal interests such as handicapped access and the spread of mandatory fire sprinklers to more and more residential buildings in the US.

So, while parts of the codes stay fixed for many years, others change rapidly, just as portfolio rules would.


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