Tuesday, October 12, 2010

All Together Now

I've written several times recently about the high correlation of stock price movements across all industries and sectors. According to Ned Davis Research, correlations now stand at 50-year highs.

As it turns out, correlations are also at historic highs across different asset classes. Commodity price movements (including gold) are tracking quite closely to price changes in stocks and bonds.

This presents a challenge to investors. The reason for diversification - the hallmark of portfolio management - is that non-correlated asset movements reduce overall portfolio volatility. If all prices are moving in tandem, however, diversification as a risk reduction tool is less effective.

There is the additional question was to why correlations are so high right now. Much of the answer seems to be centered on the efforts of many of the world's central banks to either stimulate their economy, or weaken their currency (to try to make exports more attractive), by intervening in the capital markets.

In the U.S., for example, bond prices have soared in recent weeks in anticipation of another round of quantitative easing by the Fed. The 10 year Treasury note, for example, is trading at 2.37% this morning, down nearly 70 basis points since the end of July.

This week's Buttonwood column in the Economist has a somber discussion of the highly correlated markets:

...Dhaval Joshi of RAB Capital, a fund-management group, says that there have only been four other quarters since 1980 when gold, equities and Treasury bonds have strengthened simultaneously.

... it is doubtful whether the simultaneous strength of gold, equities and bonds can last much longer. Mr Joshi says the four previous periods of triple strength since 1980 were all followed by falls in Treasury-bond prices.

Nor are rising gold and equity prices necessarily compatible. David Ranson of Wainwright Economics has looked at the relationship between gold and stockmarkets since 1824. Some might think that shares, thanks to their links with the real economy, would do well in inflationary times. But that is not what the data show.

When gold was up by more than 20% over a five-year period, the median return from large-cap American stocks in the same era was just 2.1%. And when gold fell by more than 20%, the median large-cap return was 99%.

Buttonwood: The magic bullet | The Economist

For now, the market remain well-bid. Investors are shrugging off poor economic or company-specific news, and adding to portfolios. However, if all of the buying is solely in anticipation of the Fed, this could turn out to be a false dawn.