The first person I heard keeping a track of Dow Industrials Average on a day-to-day basis was a business school senior of mine from the class of 1997. Little did I know then that in barely ten years, the world will get glued to Dow daily and intraday movements. And nothing will matter more than where the Dow was headed. We are in the age of Dow, and Dow psychology rules. The grip is so powerful that an emerging market broker in Romania after a market update to his client starts talking about what the client is interested in most, the bailout meeting. The respective client will be missing the UEFA Championship match between CFR Cluj and Chelsea to watch the bailout meeting at home.
Dow is the global pastime now. Before 2000 it was both Dow and Nasdaq. After the tech bust, Nasdaq featured less in inter-office bets and perceived connections with Indian markets. I also remember another occasion when even a shoeshine boy understood, where we are headed tomorrow was more about the Dow than anything else. The perceived connection was thought to be an unstated rule. On occasion when markets took a different turn locally compared to what the Dow was doing, news of decoupling between global and local markets featured in national newspapers and TV channels. There was always a reason why the Dow connection worked or weakened at times.
As time passed and both liquidity and the number of investors increased, the forecasting rules became simpler, if there are certainty and an up move; it is generally because of local factors. But when uncertainty comes in it’s the Dow. It did not matter what Dow returned in terms of price changes over a month and a quarter. What mattered was the daily and weekly volatility in the benchmark's price performance.
There were not many studies I read since 1996, which actually studied the correlation between Dow and Sensex or other emerging market indices and whether such comparisons really made sense. Even fundamental analysts historically have taken refuge in this, suggesting upside as a predictable certainty and downside as the Dow effect. The correlations between Dow and Sensex are poor. Rather correlation itself increases and decreases as markets move from greed to fear. At both extremes, the correlations have known to be high. This is why during contagions every market seems to be correlated.
Going a bit deeper into correlations between Dow and Sensex suggest a historical correlation of 0.69, for the last decade it has been at 0.64, the highest correlation has been since 2002 lows at 0.90 which has fallen now to 0.82 if you look at just the last year. I just ran a random check to see if the correlation could just go negative. And here I was at the first attempt, – 0.42 from 26 May 2005 to 19 Oct 2005. I did a similar exercise on another emerging market Index, Romanian BETFI. Dow and BETFI suggest a historical correlation of 0.86. December 2003 till December 2007 saw high correlation values at 0.92. Every equity index was going up at this time, no wonder such high readings you will find in many equity indices when compared to Dow. December 2000-2003, the correlation was negative at -0.68. The random check leads to a negative correlation at – 0.79 from March 2001 to October 2002.
Correlations are an illusion that we live in, as you can actually draw a cycle of increasing and decreasing correlations between Dow and Sensex. And what use is correlation anyway? Correlation as a trading indicator works miserably with not many backtesting validations.
And if we just extend the relationship to Dow and Dollar, which have been to be strongly linked, a strong dollar and positive Dow move together. Even in this pair, the correlations between Dow and Dollar can go awry, cyclically, positive correlation today and negative tomorrow. It just does not work. Once you identify that the correlation is increasing you know the assets are in sync and vice versa. It is like the classic outperformance underperformance Intermarket cycles we have talked about. There will always be a period Dow will outperform Sensex and a period when it will underperform. Just to look at one side of the cycle is extrapolation and ignoring the other side, calling it decoupling, is human.
Dow is the psychological alibi that we use to explain market vagaries. There is no other way you can explain why if the problem is in America, why did China, Russia, India, and the world fall more than the Dow. Of course, there will be some explanation for this too. But then how quantifiable is it? We at Orpheus believe that emerging markets are better indicators and lead the Dow. India formed the primary low on 21 September months before the 08 October low of Dow in 2002. Indian and Chinese Indices may have lagged at the current top, topping after the 11 October 2007 high in Dow, but emerging markets like Romania had topped as early as 24 July 2007. This is why Dow psychology remains flawed and October low might have more to do with Nikkei than Dow.