Opportunities in a High Correlation World

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Includes: AGG, DJP, EEM, EFA, ICF, IVV, IWM, TIP, XLU
by: Geoff Considine

One of the most striking features of 2008 was the fact that correlations between most asset classes went up substantially: everything declined at the same time. One of the principal motivations behind diversifying is that all of your holdings will not decline at the same time. Declines in one class will be buffered by gains in another—or at least lesser losses in others. This effect has not provided much buffer in 2008.

The table below shows the trailing three-year correlations in monthly total returns between a range of ETFs (I have used ^DJC as a proxy for DJP because of DJP’s short history).

click to enlarge

Click to enlarge

There are only three correlations in this matrix that did not increase between 2007 and 2008—and those are marked in red. The increase in correlations is substantial: every asset class was sold off at the same time, albeit in varying degrees.

The upswing in correlations reduces the value of strategic asset allocation, because benefits of diversification decline as correlations increase. The “diversification premium” is diminished. Almost any given asset allocation will look riskier if correlations are higher. On the other hand, the increase in correlations signal that the market is treating enormous swathes of the investment landscape as less differentiated than they really are—and this provides a substantial opportunity.

How might investors deal with this environment? I see three major areas that have high potential.

1. Tactical asset allocation

At the same time that correlations have gone up, prices (obviously) have come down dramatically. The stocks of many firms are very cheap right now. The tactical side of investing (when you buy) is more important because the strategic side of investing (asset allocation) is at a low point. As Warren Buffett has famously suggested: be greedy when others are fearful and fearful when others are greedy. I have personally never seen an environment in which investors are more uniformly scared than recent months.

In August of 2007, shortly before the start of the massive bear market, I showed that there had historically been a strong negative correlation between returns on major asset classes and market volatility. This means that market returns are low when volatility goes up, and vice versa. I also discussed the wide range of evidence suggesting that market risk was due for a substantial increase. This observation turned out to be quite prescient. Today, market risk is high and trending downwards—and this also has implications for returns. Declining volatility has historically been a positive sign for a range of asset classes.

I am inclined to agree with Jeremy Grantham that “high quality” stocks will deliver outsized returns over the coming years. My analysis suggests that the market has become fairly indiscriminate in separating the high quality from the low quality—and this shows up in the increase in correlations. Many investors treated almost every asset class as equally risky—so high quality stocks are available at really good prices.

The challenge of tactical strategies is that they require more active management. A position that looks attractive today may not look attractive in several months. Tactical strategies allow investors to take advantage of opportunities that may be fleeting. Similarly, the risks associated with an investment can change quickly.

2. Exploit the excessive risk aversion in the market

The higher correlations we have seen are a manifestation of excessive risk aversion: investors are trying to get out of every asset class as fast as they can. Excessive risk aversion can be judged by the prices at which options are trading—and a conservative way to exploit this is to sell options. When investors are risk averse, options prices will be high (and vice versa). Back in November of 2008, I wrote an article in which I discussed how to judge relative mis-pricing. As one example, I cited January 2010 call options on JNJ with a strike price of $65 that were selling at $5.50. My analysis suggested that these options were selling at too high a price. Today, these options are selling at $3.10. Selling options as part of a coherent strategy makes sense for the investor or advisor who understands how to value options.

3. Looking Beyond Index Investing

I have written quite a bit about the merits of investing in a portfolio of carefully selected individual stocks rather than buying into market cap weighted indexes. As correlations between the major indexes have risen, the way to exploit low correlations appears to be via a judicious combination of individual stocks. An article titled Have Individual Stocks Become More Volatile? [pdf file] (Campbell et al, 2001) shows that correlations between individual securities have experienced a long-term secular decline. This decline should allow for increased diversification benefits between individual securities.

Further, Fama and French (The Capital Asset Pricing Model: Theory and Evidence, 2004) [pdf file] showed that portfolios of low-Beta stocks have historically delivered consistently higher returns than the CAPM theory suggests (see Figure 2 in that article). Stocks with low correlations to one another also tend to be low Beta, and Fama and French’s results suggest that you can obtain more return with less risk than the market portfolio by building a portfolio out of low-Beta stocks. A challenge in this type of approach is to manage volatility associated with individual stocks—but this is not an insurmountable task. I have discussed this conceptual strategy previously.

The Long View

I fully expect that correlations will settle back down to historical levels, thereby providing a higher benefit to strategic asset allocation once again. The current low prices and the high implied volatilities of many stocks (as reflected in options prices) provide the ability for selective investors to lay the groundwork for a substantial boost in portfolio performance. Strategic Asset Allocation is a key part of long-term planning, but tactical opportunities appear to dominate the near term. The high correlations (which reduce the value of SAA for the time being) increase the potential for finding indiscriminate pricing of risk. When good companies are treated by the market as though they are just as risky as bad companies, there is an opportunity to pick up the good ones at low prices and/or short volatility on the good ones (by selling covered calls, for example). Further, even though correlations between indexes have increased considerably for the time being, it is still possible to find groups of stocks that exhibit low correlations to one another—thereby providing increased diversification benefits.