Tuesday, April 5, 2011

"All Together Now" - The Markets Move As One

I posted a note yesterday that noted that the Fed's actions last fall - so-called QE2 - were very successful, at least in terms of the markets.

The S&P 500, for example, just recorded its best quarterly return since 1988: +5.9%. For the last 6 months, the S&P is up nearly +17%.

Bonds have also held in nicely, with the 10 year Treasury yielding 40 basis points less than a year ago, at 3.40%.

So what's to complain about?

Not much, I guess, unless one stops to consider that all sectors - stocks, commodities, bonds - have moved in the same direction recently. To me, this implies that investors are not necessarily investing with an eye towards an improving economy, or threats of inflation or deflation.

No, it seems more likely that most investors are realizing that the central banks of the world are providing large boosts of liquidity which are making their way into the global markets. The best way to make money, then, is to buy assets - any assets - and join the party as prices rise as one.

Problem is: What happens when the central banks scale back?

Last Sunday's New York Times carried a column authored by Jeff Sommer that discussed the recent synchronized movements of the world's markets. Here's an excerpt from the piece titled "When Markets Move as One":

... “In current market conditions, there is little point trying to understand the nuances between different asset classes, or the relative value within asset classes. Commodities behave like bonds, which behave like equities. They are no longer easily identifiable, uncorrelated trades.”

Furthermore, Mr. Williams said, close correlation of seemingly disparate assets implies that many portfolios may not be as diversified as we may think.

While the ride is enjoyable, there is the more worrisome thought of the other side of the "risk on" trade: What happens if everyone heads for the exits at the same time?

Mr. Sommer goes on, quoting Eswad Pasad, a professor at Cornell University:

“Financial markets are supposed to be very helpful in diversifying risk, but the whole point is you want uncorrelated returns across markets,” he said. “If markets are more correlated now, it may be because people are trying to diversify by investing globally, but when there is a trigger event — when something nasty happens in the world — they sell assets across markets, and the usefulness of this entire diversification strategy must come into question.”

When the Markets Move as One - NYTimes.com