Correlations tend to one

05Mar07

We were genuinely surprised to hear investors and commentators alike were shocked fo find that during periods of intense market stress, like last week, that markets would tend to move together in the same direction. It has long been known* that during bear markets and especially during negative market extremes, that global equity market correlations tend to one.

While commentators today may blame hedge funds as the common source of the selling, this tendency for markets to move together as one has been on the global market scene for quite some time. Frankly, the source (or sources) of the global market shudder are irrelevant. What is somewhat surprising is that seemingly unrelated markets also moved down last week.

FT Alphaville quotes Merrill Lynch strategist Rich Bernstein on the now high correlation of assets like commodities with the equity markets. Bernstein believes that the unrelenting search for uncorrelated assets has coincidentally forced “uncorrelated to become correlated.”

James Picerno at the Capital Spectator who has long preached the power of diversification and portfolio rebalancing notes how only asset classes like Treasury bonds and TIPS were spared the selling last week. He notes that while volatility is generally unwelcome, it does allow investors opportunities to rebalance their portfolios.

David Gaffen at MarketBeat also demonstrates the increase in asset class correlations and highlights another asset, gold. Gold has long been touted as the ultimate “safe have” asset class for its negative correlations during times of market stress. Unfortunately, the shiny metal has not held up its end of the bargain this time around.

There are no guarantees that portfolio diversification will work in each market cycle and on your schedule. Diversification, to the degree to which it works, works out over time and across cycles. Asset classes by their very nature are not hedges. There are really only a few ways to truly hedge against a market decline.

First, is of course highly quality cash equivalents, i.e. Treasury bills. Second, are instruments that provide a guaranteed negative correlation with the equity markets. This would include short positions in equity index futures or equity index ETFs, long positions in equity index puts, and long positions in the new batch of inverse market ETFs. (Or some combination therein.) Absent a position in these “true” hedges, diversification is at best a bet on history playing out once again to your portfolio’s benefit.

*See Erb, Harvey and Viskanta, “Forecasting International Equity Correlations,” (pdf) Financial Analysts Journal, Nov./Dec. 1994, pp. 32-45.

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