Asset Inflation: Correlations Are All Positive

by: MyPlanIQ

Central banks around the world have tried very hard to stimulate economy using loose monetary polices. Quantitative easing policies adopted by the Federal Reserve have made interest rates extremely low. This has had a profound impact on investing in "safe" assets:

  • Bank interest rates are extremely low: based on, checking interest rates range from 0.2% to 0.98%.
  • Money market rates are also sub 0: again based on, money market accounts range from 0.49% to 0.64% jumbo (for $100k+ accounts).
  • Vanguard total bond index (VBMFX, BND) is yielding about 1.56%. The fund represents an intermediate bond fund that is the total capital weighted bond market index.
  • Long term 10 year Treasury note is yielding 1.62%, close to the lowest level since 1962.

For many income investors such as retirees or family households, they have no choices other than to invest in other assets that have higher yields. These higher yielding assets include high yield bonds, international or emerging market bonds, high yield stocks and even rental properties. To the extent, the reflation of higher yielding or risk asset prices has been very visible. The following shows asset returns in the past 12 month periods:

Asset Class Trends (As of 12/05/2012)

Asset Class 1 Weeks 4 Weeks 13 Weeks 26 Weeks 52 Weeks Trend Score
Intl Stocks 1.7% 3.3% 7.8% 15.3% 10.7% 7.7%
Emerging Mkt Stocks 2.3% 2.3% 8.8% 13.1% 8.9% 7.1%
High Yield Bonds 0.7% 0.3% 2.6% 8.6% 14.5% 5.3%
US Stocks 0.1% 1.4% 1.1% 8.5% 14.2% 5.1%
US REITs 1.0% -0.5% -3.3% 3.5% 18.1% 3.8%
Long Term Treasuries 0.3% 0.9% -0.5% 1.3% 8.9% 2.2%
Commodities 0.0% 2.0% -2.7% 10.5% 1.3% 2.2%
Intl Bonds 0.4% 0.8% 1.4% 3.3% 4.1% 2.0%
US Bonds 0.2% 0.0% 0.4% 2.3% 5.0% 1.6%
Cash 0.0% 0.0% 0.0% 0.0% 0.1% 0.0%
Gold -1.5% -1.4% -0.1% 4.4% -3.1% -0.3%

Other than Gold, commodities and cash, all other assets (including U.S. Bonds) have meaningful 12 month returns.

With most risk assets being at the elevated levels, it is not surprising that they are correlated positively. However, in the process of depressing yields of short term rates, "safe" asset prices have also been lifted (bond yields and prices have inverse relationship). In fact, looking at asset trends & correlations for major asset classes recently, one can find they are all correlated positively with U.S. stocks since June this year:

Major asset classes:

  • U.S. Stocks: SPY
  • U.S. Bonds: BND or AGG
  • U.S. REITs: VNQ or IYR
  • Intl Stocks: EFA
  • Emerging Market Stocks: EEM or VWO
  • Long Term Treasuries: TLT or IEF
  • Commodities: DBC

(Click to enlarge)

To some extent, global central banks have indeed managed to pump every asset class up. What is even more interesting (and concerning) is that even long term Treasury bonds (NYSEARCA:TLT) is now positively correlated with U.S. stocks. But it remains to be negatively correlated with other risk assets:

(Click to enlarge)

The consequence of the above positive correlations among bonds and stocks is that a traditional asset allocation portfolio that only allocates in stocks and bonds is now in danger of losing its diversification benefit.

Fortunately, long term Treasury bonds and gold (GLD or IAU) are still two radical assets that are less correlated with stocks and bonds (two most popular asset classes). Permanent portfolios like Harry Browne's will still do well. On the other hand, extending stocks to international and emerging markets in a portfolio such as Permanent Global Portfolio ETF Plan has apparent diversification benefit, given the negative correlations shown between long term Treasuries and international and emerging market stocks.

Since all assets are inflated, active investors can adopt a second line of defense to adopt a more tactical approach to avoid future market downturns. Trend following or other tactical approaches such as valuation based can be used.

Disclosure: I am long SPY, TLT, GLD, IYR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.