Opportunities in a High Correlation World

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

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.

Comments

[E.D. Hart:]

Great Article Geoff,
I have been a reader of yours for a while and I always appreciate the detailed analysis, and the specific examples. Can you provide us with an update on past suggested low beta portfolios that you've suggested so see how they are holding up in the current environment? Thanks,
Eric

Feb 03 12:02 PM

[Geoff Consi...:]

Eric:

See the following discussion:

www.prweb.com/releases...

The original research paper describing the analysis is here:

www.quantext.com/Econo...

Geoff

Feb 03 02:23 PM

[Chris B:]

In 1999, I saw that the tech bubble was about to burst, but I held onto my one remaining stock, Wal Mart, based on the following assumptions:

a) Unlike the tech stocks, WMT had a reasonable PE, so it would hold its price even as the tech sector, and only the tech sector, collapsed.

b) As investors fled technology, their money would flow into high-quality stocks.

Well, as everyone knows, WMT never again reached its high near $70. Investors sold WMT down to the $40's to cover their tech losses, and few new buyers stepped forward because tech had wiped them out. Meanwhile, new money didn't flow into different sectors of the stock market, it flowed into cash!

In hindsight, I should have seen the ENTIRE MARKET as one sector in investors' portfolios, competing with cash, real estate, currencies, commodities, commercial paper, treasuries, private businesses, property, etc. I should have thought of market participants not as a fickle herd bouncing from sector to sector in the stock market, but as short sellers caught in a squeeze, retirees who had lost future income, or leveraged index buyers/sellers. When things go badly, they simply hit the "sell" button on their browser. Selling out is much easier to do now than it was 30 years ago!

Thus, anything that can be bought or sold through your online broker is correlated, perhaps irrationally. For investors who want to protect their portfolio balances, that leaves few options. Hedge funds and short ETF's have multiplied in the last 10 years, but their shortcomings are becoming obvious. Even commodity ETF's have failed to preserve value this time around. The reason: they all have a "sell" button. Soon, treasury and gold investors will learn this lesson, as they too have sell buttons now.

Thus, if you want portfolio or income stability, buy a rent house (and don't overpay), a timber tract, a professional education, or a CD ladder. The illiquidity of these investments is what makes them less correlated with the more liquid securities market.

Feb 03 03:38 PM

[Jase:]

Geoff,

Excellent article. To what extent do large currency fluctuations contribute to this increased correlation? At the beginning of 2006, 2007, 2008, and 2009, the value of US Dollar Index was at ~90, ~83, ~76, and ~81 respectively. Those are massive % swings. The run-up from its lows of 70.70 in March 2008 to its recent high of 88.46 in November of 2008 is an astounding, if not unprecedented, percentage gain. Surely this must influence your correlation results. My question is, how?

Feb 03 04:32 PM

[otbricki:]

3000 years ago the Talmud recommended 1/3 in real estate, 1/3 in business and 1/3 in what is essentially fixed income.

After all those years, still pretty good advice.

Feb 03 04:52 PM

[Owen:]

otbricki: The Talmud was only 1500 years ago, and since Jews were forbidden from charging each other interest, the last one third was to be in ready-to-use cash on hand.

Also keep in mind that 1500 years ago, most of the world's economic productivity came from agriculture, so keeping a third of your investments in land made more sense then than it does today.

The Talmudic scholars were brilliant people, but you cannot blindly apply their investment advice to today's economy without first understanding the underlying conditions that prompted it.

Feb 03 05:30 PM

[Pidepiper7:]

Nice article. I've made very similar observations and have been investing accordingly.

For the past couple months, everything has been rising and falling virtually in unison with virtually no regard to the quality of individual stocks.

I've never seen the market as driven by the media/political/news cycle as is this market. By keeping a close watch on the general "pulse" (by reading as much news as possible, watching cheezy financial shows, etc), I've had considerable success in predicting upward/downward movements in this stagnating, up-down market; investing when the "mood" was slightly more positive and getting out of the market when the "mood" turned slightly more sour.

Furthermore, in order to best exploit the market-wide ups and downs, I've been targeting small-caps. Because small-caps tend to magnify the upwards/downwards movements of the market for that particular day/week; usually rising or falling 2-3X more than the indexes. The underlying fundamentals of the stock(s) have been nearly irrelevant (except to identify and avoid those stocks which had not yet been as crushed by this market as I thought they could be).

My return for only the past two months has been slightly more than 100%.

I also agree with Jeremy Grantham that “high quality” stocks will deliver outsized returns over the coming year. I would add to this, however, that "high quality" small-cap stocks may deliver even greater outsized returns as fearful investors have abandoned small-caps at an even greater pace.

I plan on slowly moving back into a more diversified portfolio over the coming year(s). But not until I've milked the current opportunities for as much as their worth.

Feb 03 08:51 PM

[Mark Hines:]

Geoff- Good stuff!

Feb 03 10:30 PM

[JLBR:]

Correlation (among asset classes) on the way down does not signal correlation on the way back up. It simply suggests a common cause of all the selling that was independent of asset class. Like fear, for example, and incomprehension. Most people in the country with any kind of investments at all (401-Ks, for example) were mystified by the bank failures followed by government panic last September. One day everything seemed fine, the next day there was a crisis. Like any rational people confronted with a mysterious, incomprehensible force, investors cut their losses and hunkered down. It's not a crisis of confidence, but of comprehensibility. Things didn't make sense. Investors will come back when they think they do understand what's going on, and then they will (as a group) prefer the same mix of asset classes.

Feb 04 01:03 AM

[Geoff Consi...:]

PiedPiper and JLBR:

I agree with both of you. Correlations temporarily spike up when people start to think the world is ending. This both makes SAA less effective and makes tactical strategies more effective--but both of thes effects are not long-term. When people are indiscriminately fearful or optimistic, there are opportunities and we are in the former. With regard to small caps--this is something I have been thinking about, too. In the past, blue chip stocks were large cap and also perceived as safer. We have learned an important lesson in this regards. Certain large cap stocks have been exploding spectacularly--market cap is not a signal of "quality".

Feb 04 08:03 AM

[Dunvegan:]

Great article Geoff. Your opinions arealways backed up with data which I greatly appreiate. Any suggestions on low beta stocks? Where do we get the qaunts to evaluate stocks?

Feb 04 10:07 AM

[searcher:]

The wisdom of the ancients is never so wise as when it validates ours. It's not solely the indiscriminant apportionment of risk premium but, additionally, the lack of liquidity that requires the selling of those assets for which a market is still relatively available.

Feb 04 12:07 PM

[Deep Value:]

If the downturn is bad enough everything is correlated. You would think with credit as bad as it is the rental housing market should be doing well. But a buddy of mine that owns a few buildings called asking for referrals. He said a lot recent grads are staying with their parents longer and more single people are looking for roommates instead of one bedrooms and studios. It's getting nasty out there.


On Feb 03 03:38 PM Chris B wrote:

> In 1999, I saw that the tech bubble was about to burst, but I held
> onto my one remaining stock, Wal Mart, based on the following assumptions:
>
>
> a) Unlike the tech stocks, WMT had a reasonable PE, so it would hold
> its price even as the tech sector, and only the tech sector, collapsed.
>
>
> b) As investors fled technology, their money would flow into high-quality
> stocks.
>
> Well, as everyone knows, WMT never again reached its high near $70.
> Investors sold WMT down to the $40's to cover their tech losses,
> and few new buyers stepped forward because tech had wiped them out.
> Meanwhile, new money didn't flow into different sectors of the stock
> market, it flowed into cash!
>
> In hindsight, I should have seen the ENTIRE MARKET as one sector
> in investors' portfolios, competing with cash, real estate, currencies,
> commodities, commercial paper, treasuries, private businesses, property,
> etc. I should have thought of market participants not as a fickle
> herd bouncing from sector to sector in the stock market, but as short
> sellers caught in a squeeze, retirees who had lost future income,
> or leveraged index buyers/sellers. When things go badly, they simply
> hit the "sell" button on their browser. Selling out is much easier
> to do now than it was 30 years ago!
>
> Thus, anything that can be bought or sold through your online broker
> is correlated, perhaps irrationally. For investors who want to protect
> their portfolio balances, that leaves few options. Hedge funds and
> short ETF's have multiplied in the last 10 years, but their shortcomings
> are becoming obvious. Even commodity ETF's have failed to preserve
> value this time around. The reason: they all have a "sell" button.
> Soon, treasury and gold investors will learn this lesson, as they
> too have sell buttons now.
>
> Thus, if you want portfolio or income stability, buy a rent house
> (and don't overpay), a timber tract, a professional education, or
> a CD ladder. The illiquidity of these investments is what makes them
> less correlated with the more liquid securities market.

Mar 09 05:11 PM