Thursday, December 16, 2010

Correlation Does Not Imply Causation

A key scientific principle is that correlation does not imply causation - basically, even though event A and B may be correlated, it's not necessarily true that one caused the other. This is very true in the investment world, in large part because financial markets are so complex and there are so many different variables at work. After all, with trillions of investment dollars sloshing around worldwide, it's highly unlikely that a singular event will be the absolute cause of something else happening. Even when venerable investment banks Bear Stearns and Lehman Brothers failed, many securities fell for reasons relating to their collapse or financial destruction elsewhere - it's simply impossible to tell.

I bring this up because I read an article on this morning
which stated the following:

"The charts of the U.S. dollar index and the
SPDR S&P 500 ETF clearly show the inverse relationship they have. Right now it seems everything is directly connected with the dollar; it has been like that most of the year."

While the article doesn't explicitly imply that the two are correlated, the author seems to suggest that because certain indexes and financial products have a chart pattern inverse of the dollar, that the dollar's movements seem to affect them. While this may be the cause in some extreme instances, ultimately, the dollar is moving because of other variables - monetary and fiscal policy, economic indicators and geopolitical issues, among other things. To understand why a security is moving, you have to dig a little deeper; don't take a chart pattern at face value.

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