Diversification Strength: U.S. Dollar Index vs Crude Oil
The Diversification Strength analysis method looks at the correlation between the U.S. Dollar Index and Crude Oil, but with a small twist. Unlike most correlations studies that use traditional price action or percent change data, this evaluation method is based on RISK. To be specific, the Diversification Strength uses drawdown risk at the heart of its correlation analysis. After all, non-correlated risk is exactly what we are trying to focus on as we build portfolios with various markets and asset groups.
Diversification Strength Overview:
Our definition of risk begins with the Underwater Volume Index (UVI), which continually measures risk based on a markets magnitude and duration of drawdown. We then construct a rolling correlation between each markets UVI, looking for periods of high or low correlation phases. Markets with high correlation levels typically experience drawdown periods in a similar manner. Not much diversification can be had between the U.S. Dollar Index and Crude Oil if their drawdowns are closely tracking one another. In this case the markets would be in a negative diversification phase, shown on the chart as the shaded in gray area.
If on the other hand, the markets are in a low rolling UVI correlation phase we would expect drawdown periods to move independent to one another. This non-correlated phase, when related to diversification, is the key to a well balance and strong portfolio. In this case the markets would be in a positive diversification phase, shown on the chart as the tan shaded area.
- Gray Shading: Negative diversification phase showing high risk correlation between the markets.
- Tan Shading: Positive diversification phase showing low risk correlation between the markets.
- Blue Line: U.S. Dollar Index equity curve based on the Value Added Weekly Index .
- Red Line: Crude Oil equity curve based on the Value Added Weekly Index.
U.S. Dollar Index and Crude Oil Diversification Strength: