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As more money has chased (...) risky assets, correlations have risen. By the same logic, at moments when investors become risk-averse and want to cut their positions, these asset classes tend to fall together. The effect can be particularly dramatic if the asset classes are small - as in commodities. (...) This marching-in-step has been described (...) as a 'market of one'.
The Economist, March 8, 2007.
Financial investors have sophisticated arguments to explain their stampede into commodities. Many say they provide returns that are not correlated to equities (...) improving a portfolio's diversification.
The Economist, August 20, 2008.
We provide detailed empirical evidence on the extent to which the prices of, and the returns on, passive investments in commodity and equity markets move in sync. We also ask whether the intensity of these co-movements has increased over time.
One might expect commodities and equities to not move in sync. There is no theoretical model of a common factor driving the equilibrium relation between equity and commodity prices, and the traditional risk factors behind equity returns have historically had no forecasting power in commodity markets (Erb and Harvey [2006]).
Yet, arguments have long existed that equities and commodities should be negatively correlated (e.g., Bodie [1976]; Fama [1981]). As an empirical matter, there is also evidence that commodity futures returns do vary with systematic risk after controlling for hedging pressures (Bessembinder [1992]; de Roon, Nijman, and Veld [2000]; Khan, Khokher, and Simin [2008]).
Almost all empirical studies of the relationship between equity and commodity returns are based on data series that end in 2004 or 2005. In the last five years, however, two major changes have taken place in commodity markets.
First, the first sustained world-demanddriven commodity price shock of the last 20 years started in 2004 (Kilian [2009]). Historically, the real prices of crude oil and equities have moved (upward) in tandem only during episodes of growth in world demand for industrial commodities (Kilian and Park [2009]). Generalizing, it is an open question whether equities and commodities as a whole started to move more in sync amid this commodity boom.
Second, not until 2003 did financial institutions - including hedge funds and commodity index funds - sharply increase their share of open interest in...