Why Record Stock Correlations Are An Adverse Feedback Loop To Market Participation

Today's link comes from the blog Zero Hedge, and quotes extensively from work done by Nicholas Colas of Bank of New York.

One of the frustrating parts of today's investing environment (besides low interest rates, uncertain future tax policies, etc.) has been the high correlation between assets. For example, as this post notes:

U.S. equity correlations among the 10 industrial sectors of the S&P 500 remain near historical highs, as 7 out of the 10 sector ETFs show correlations with the S&P 500 in excess of 90%. Only Healthcare, Utilities and Consumer Staples are lower, and they're stuck in the 80% range.

Put another way, for managers looking to add value to portfolios through either stock or sector selection, 2010 has not been a good year. Little wonder that a Merrill Lynch report that landed in my email inbox this morning indicated that only 16% of the active stock managers they follow have outperformed the Russell 1000 index YTD.

(Commercial time: the equity portfolios that I manage have essentially tracked my benchmark, which is the S&P 500. A small victory).

And then there's the argument about diversification between asset classes.

The whole point of a diversified portfolio is that asset classes should move in different directions. However, since the beginning of the year, interest rates and stock prices have moved in the same direction. As I have written several times, this follows the Japanese experience over the last 20 years during their deflationary battle.

This means that owning bonds has been satisfying for investors this year in terms of absolute returns (since interest rates have moved lower, pushing bond prices higher) but bonds have not helped to balance principal valuations in portfolios.

Even overseas, the correlations between emerging market and developed market equities has been remarkably high.

What are the investment implications? Mr. Colas continues:

{This is} not a healthy market. The mathematical benefits of diversification require assets that exhibit low-to-no correlation amongst themselves. When everything moves in synch, asset allocators have to pull in their horns. Wonder why investors are shunning risk and buying bonds? Part of the reason is clearly that the historically proven benefits of diversification just are not working as well as they once did.

Some of my fellow portfolios managers argue that this will not continue, and that we will soon return to a period of significant differences in returns among asset classes.

I hope so too, but as one of my earlier posts on the dominance of program and high frequency trading in the stock market indicates, it is not clear to me now how all of this changes.


Why Record Stock Correlations Are An Adverse Feedback Loop To Market Participation