Nicholas Colas, chief market strategist at BNY ConvergEx, did an experiment this week.
He ran one of his daily analytical musings through the www.iwl.me website, to see what famous author his writing style most closely resembles.
The verdict was science fiction novelist Arthur C. Clarke.
And, Colas says he can see how that might be reasonable — given that the piece of prose he submitted for literary analysis was his latest report on asset price correlations.
As he notes:
For those of you unfamiliar with his work, his best known effort was 2001: A Space Odyssey . The story, which leveraged Clarke’s amazing facility in the realm of science fiction, was co-written by Stanley Kubrick and made into book and movie simultaneously. Well, science fiction is not exactly what I know or like, but Sir Arthur Clarke was a fantastically successful 20th century author so I will internalize the assessment as a positive.
But, in reality, there is something “other worldly” about the monthly correlation analysis we track for risk assets, and this month’s summary just reinforces that theme. We all learn in school – whether that be undergrad, business school, or CFA Level 1 – that assets have different correlations to each other. They do not, generally, move simultaneously in the same direction. If cyclical stocks rally, consumer nondurables go down. If gold spikes, bonds probably aren’t going to rip higher in price. That lack of correlation allows asset managers to manage risk, since offsetting assets will lower portfolio volatility over time while maximizing return.
Hence he concludes — and we recommend you start imagining giant babies drifting through space right around now — that we are in fact living in some sort of alternative investment universe.
What’s more, according to Colas, the phenomenon of increased correlations is actually accelerating in some areas. Here’s his latest summary:
* Among U.S. stock market sectors, correlations declined very modestly, but remain at near-record highs. Five of the ten industries we track still have correlations to the S&P 500 of at least 95%, and the lowest correlations are around 83% (Utilities and Consumer Staples). Four months ago the lowest correlations were 65-66% (Health Care and Utilities.
• Rising markets and lower expected volatilities (as measured by the CBOE Volatility Index, or VIX) do tend to push down the correlations among industry sectors. However, even last month’s strong rally in U.S. stocks did little to reduce how much sectors move in tandem with the market overall.
• High yield bonds reached a new high for correlation with U.S. stocks. In contrast, high grade corporate bonds remained one of the least correlated asset classes – a real bright spot in the analysis.
• Precious metals – we track gold and silver – both saw rising correlations to U.S. stocks in July. That is a reversal of a trend that started early in 2010, and price movements in precious metals have become more tied to equity priced over the past 60 days.
• Currencies bucked the trend to higher correlations, at least among the Euro, Aussie dollar and Yen. In fact, the much maligned Euro is at 8 month lows in terms of its relationship with U.S. stocks.
As to the explanation, Colas puts forward two popular ideas.
First, that the correlations are indeed a function of high frequency trading. This type of money management dominates day-to-day trading of US equities, he says. And one strategy in particular — the arbitrage of exchange traded funds (ETFs) to underlying stocks — could partially explain why equities and sectors move closer to indices.
This would be particularly true, he says, in a rising market where the SPY ETF, the world’s most popular equity ETF which tracks the S&P 500, gets a significant amount of inflows.
Secondly, the correlations may also be down to macroeconomic factors — namely the Federal Reserve’s monetary policies and a rolling set of concerns about sovereign debt risk.
Trading has come to represent the bare obvious, he says — risk on, or risk off.
But, he adds, there is a price to be pay for all this correlation. As he concludes:
I would only point out that there is a real price to pay for such high correlations. This isn’t science fiction any more, it is science fact. The most dramatic development of the last 12 months is that retail investors have pulled cash out of U.S. equity mutual funds even though stocks have done well. Some has gone into stock ETFs, yes. Far more, however, has gone into bonds. Investors, even if they have not learned it formally, understand that diversification means lower correlations. As long as stocks, bonds, precious metals, and other assets all move in lock step, retail investors will most likely favor less risky assets.
(H/T the FT’s Telis Demos)
Related links:
Correlation fatigue, emerging market edition – FT Alphaville
BarCap on correlation and ETFs – FT Alphaville
Did Socgen use ETFs to liquidate Kerviel positions? – FT Alphaville