When Correlations Rhyme

Before I start this piece let me give you a blast from the past, the columnist conversation comment that I most frequently reprint, from this post:


David Merkel
Make the Money Sweat, Man! We Got Retirements to Fund, and Little Time to do it!
3/28/2006 10:23 AM EST

What prompts this post was a bit of research from the estimable Richard Bernstein of Merrill Lynch, where he showed how correlations of returns in risky asset classes have risen over the past six years. (Get your hands on this one if you can.) Commodities, International Stocks, Hedge Funds, and Small Cap Stocks have become more correlated with US Large Cap Stocks over the past five years. With the exception of commodities, the 5-year correlations are over 90%. I would add in other asset classes as well: credit default, emerging markets, junk bonds, low-quality stocks, the toxic waste of Asset- and Mortgage-backed securities, and private equity. Also, all sectors inside the S&P 500 have become more correlated to the S&P 500, with the exception of consumer staples.

In my opinion, this is due to the flood of liquidity seeking high stable returns, which is in turn driven partially by the need to fund the retirements of the baby boomers, and by modern portfolio theory with its mistaken view of risk as variability, rather than probability of loss, and the likely severity thereof. Also, the asset allocators use ?brain dead? models that for the most part view the past as prologue, and for the most part project future returns as ?the present, but not so much.? Works fine in the middle of a liquidity wave, but lousy at the turning points.

Taking risk to get stable returns is a crowded trade. Asset-specific risk may be lower today in a Modern Portfolio Theory sense. Return variability is low; implied volatilities are for the most part low. But in my opinion, the lack of volatility is hiding an increase in systemic risk. When risky assets have a bad time, they may behave badly as a group.

The only uncorrelated classes at present are cash and bonds (the higher quality the better). If you want diversification in this market, remember fixed income and cash. Oh, and as an aside, think of Municipal bonds, because they are the only fixed income asset class that the flood of foreign liquidity hasn?t touched.

Don?t make aggressive moves rapidly, but my advice is to position your portfolios more conservatively within your risk tolerance.

Position: none

This article is motivated by this article from the estimable Morningstar.? Correlations are high among risk assets; the only place to lower correlations are cash and high quality long debt.? Guess what this period reminds me of?? 2006-2008 prior to the crisis.

Now there are differences, though the prime driver is central banking in both cases.? In the earlier period, they were tightening slowly.? The mistake was not tightening rapidly, much earlier.? In this era, the floodgates of monetary excess have been wide open for three years.? The error here is assuming that monetary policy can work miracles when the economy is overlevered from the prior boom.

When the ordinary actors of the economy can’t borrow because they are overindebted, monetary policy has a hard time producing any long-term useful result.?? Yes, it can spur a short-term move to risk assets.? It can twist the Treasury curve in the short-run.

This piece isn’t about monetary policy.? It’s about correlations in asset prices.? When risky assets get very correlated with each other, and the only alternative game to play is buying high quality bonds, it is an unstable situation that portends lower risky asset prices.

Color me neutral now, because the supply of cash to invest in high yield bonds, stock IPOs, and private equity is substantial.? But don’t be surprised if asset class performance reverses one year out from now.

One thought on “When Correlations Rhyme

  1. If you have not already compare the s&p 500 with the price of an Australian dollar in Japanese yen.

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