One of the major themes since 2008 has been the immense increase in correlations among asset classes. While this was already a growing trend since mid decade with the proliferation of computerized trading techniques and the rise of the ETF (i.e. when an ETF is bought en masse, all underlying equities are bought regardless of individual merits…. and vice versa) – it has accelerated in the 2008-2011 period. Headline risk and macro movements have come to dominate causing neck breaking whiplash. We call this "risk on", "risk off" – although I've called it 'student body left (right) trading' before the former terms became popular. While there have been times these correlations lessened during 2010 and early 2011, the back half of 2011 brought the return of this action in force. To wit, James Grant has noted that in the entire history of the S&P 500 there have been 11 instances where 490+ of the 500 stocks traded in the same direction. Of those 11, 6 have happened since July 2011. An incredible statistic. Essentially each day you "buy risk" (risk on) or you "buy US Treasuries" (risk off) – and every 24 hour period is unto itself, with no memory of the previous day.
This type of movement has created havoc for anyone trying to outperform the index, because often the market moves down (en masse) than 48 hours later a rumor or a 'rescue' will move all the same assets up en masse. And this gyration continues day after day, week after week, making it impossible to ride this bucking bronco. To that end, both mutual funds [Dec 20, 2011: Average Mutual Fund Down 5.9% with a Handful of Days Left in the Year] and hedge funds [Dec 20, 2011: Every Major Hedge Fund Strategy Also a Loser in 2011] have had a horrid year trying to beat the indexes. Last evening, I went through the Morningstar top fund performers of the year to see what I could glean. Not much. It was a whose who of utility (yield) mutual funds – trailed by dividend paying (yield) large cap healthcare and REIT (again a reach for yield) funds. These are now the most crowded trades on earth, now that gold has been bludgeoned of late. As these 'safe' sectors become ever more crowded, they are becoming less safe by the week – we all know how these crowded trades end. It is just a matter of when.
As I analyze the back half of the year, there has been no place for trend trading or creating multi month strategies – it has been "get in, scalp, and get the hell out" – preferably in 72 hours or less. Rinse, wash, repeat. Only a market the daytrader or very short term scalper can thrive in and even he/she has had trouble because so many of the movements occur overnight due to Europe, so U.S. markets usually gap up or down at the open and within 20 minutes go sideways the rest of the session.
But back to the lemming like behavior of risk on, risk off – the NYT takes a closer look:
(note: for some reason, I cannot embed a nice graphic from the NYT story – so go here to take a look)
- The prices of stocks, bonds and a host of other financial assets, which in normal conditions more often than not move in a diversity of unpredictable directions, are increasingly surging up or down in lockstep. The rise in correlation between individual stocks, but also between completely separate asset classes like stocks and gold or stocks and oil, “has been one of the big themes of the investment climate this year,” said Marc Chandler, a market strategist at Brown Brothers Harriman in New York.
- The chief explanation for the correlation is the great uncertainty facing investors — mainly over the crisis in Europe, which has raised the specter of the potential bankruptcy of governments and a collapse of the banking system.
- With every bit of bad news, nervous investors around the globe have been selling many of their positions across all asset classes, no matter what they are, driving prices down, and rushing into perceived safe havens like cash and United States bonds. But sometimes just a day or so later, with a glimmer of hope that Europe is pulling away from the abyss or that the United States is picking up steam, newly optimistic investors turn around and rush back from cash into harder assets, like stocks, foreign bonds or commodities, pushing prices higher together.
- “When things are less stressed, stocks and other investments move according to other more fundamental factors like a company’s earnings or its balance sheet,” said Maneesh Deshpande, managing director for global equity derivatives strategy at Barclays Capital. “But when macro fears take over, they move in flocks.”
- In November and December, a common measure of correlation within the Standard & Poor’s benchmark 500-stock index reached as high as 90 percent, the highest since 1996, according to Barclays calculations.
- For much of the decade leading up to the financial crisis in 2008, the measure of correlation between the 50 biggest stocks in the S.& P. 500 generally stayed between 10 percent and 40 percent.
- With so much money sloshing around from one day to the next, the high degree of correlation poses a challenge for active fund managers or other stock pickers who pride themselves on their ability to discriminate between stocks or other assets. It may be one reason that some hedge funds are having a tough time.
- It is also a problem for ordinary investors who have traditionally tried to protect their portfolios by spreading risk over a broad basket of assets, so that if some go down in price, others will increase. But how can you protect yourself in a world where investments rise or fall together?
- The realized correlation within United States equities in the S.& P. 500 is now higher than in 2008, Mr. Curnutt said. But, he said, it was not just stocks: there has also been an increased correlation between oil and the euro, for example, and other assets like stocks and gold, and between Italian government bonds and Italian bank stocks. “The commonality they have is they are not cash,” Mr. Curnutt said. Investors are “jumping out of cash and into something else.”
- The official monetary policy in the United States — keeping interest rates close to zero — is also exaggerating the phenomenon, Mr. Curnutt said, because savers have little incentive to stay in cash and instead rush en masse into other investments when they see glimmers of stability and higher returns elsewhere. “During this crisis, there has been one big trade out there. Either risk on or risk off,” Mr. Chandler said.
Any securities mentioned on this page are not held by the author in his personal portfolio. Securities mentioned may or may not be held by the author in the mutual fund he manages, the Paladin Long Short Fund (PALFX). For a list of the aforementioned fund's holdings at the end of the prior quarter, visit the Paladin Funds website at http://www.paladinfunds.com/holdings/blog