There’s a common ploy used by many analysts and reporters that often does not stand up to close scrutiny and would in fact be mocked by academics. The ploy is to take two time series and put them on the same chart while using different scales.
Such a ploy is often used to demonstrate a closer relationship between the two variables than actually exists. A current example is the a chart of the dollar-yen rate and Japanese stocks.
The Nikkei Vs. Yen
This Great Graphic ran in the Financial Times. It was created from a data base provided by Thomson Reuters. The chart begins at the start of 2013. It seems like a logical place to begin as Abe was elected at the end of 2012. However, why is the Nikkei’s 10,000 level (left scale) at the same level as JPY80 (right scale)?
The truth is, there’s no compelling reason except that it makes the chart more aesthetically pleasing and allows one to argue the closeness of the fit between the yen and Nikkei. Investing is many things, but it most certainly is not a beauty contest.
The Nikkei Vs. Yen: Not As Close
Here’s the same time series indexed so that each begins at 100 at the start of 2013. It was created on Bloomberg. It shows that the relationship is not nearly as tight as suggested by the first chart. This is important for investors. The relationship can inform investment strategies and hedging strategies.
The first chart looks as if the Nikkei and yen have performed similarly. The lower chart demonstrates that this is not the case. Beware.
Implicit, too, in the sophistry is the idea that correlations can be eyeballed. Maybe they can — sometimes. But it reminds me of when I recently went canoeing. I stuck the oar in the water and looked down. It looked like the oar was bent. I quickly pulled the oar out of the water and found it was still straight and true.
The Nikkei-dollar-yen correlation moves around quite a bit, which is something else that the first chart does not seem to reflect sufficiently. The correlation between the percentage change in the Nikkei and the percentage change in the dollar-yen rate over the past 100 sessions is near 0.40. Last September it was at the highest level of the Abe’s tenure — close to 0.63. Last June, this 100-day correlation (on the percentage change) dipped into negative territory.
It is said that Euclid once claimed there was not a ‘royal road’ to geometry, which meant there was no shortcut. In my experience, the same is true about investment. There’s no substitute for rigorous, critical thinking and doing one’s homework. Be suspicious of fallacious thinking regardless of source or form.