Dr Max Golts, of Bay Hill Capital Management, a mathematician and quant formerly with GMO, wrote in "Diversification, Optimization and Liquidity":
Diversification is arguably the oldest and the best way to manage risk.
There are about 5 to 9 effective GDP-weighted currencies out of about 180 official currencies in the world, quantifying the ongoing 'currency wars'. In general, the markets are much less diversified now than they were in the past. Very concentrated markets present a challenge for the classical mean-variance optimization since the returns are highly correlated and the covariance matrix is very ill-conditioned. A low level of diversification may lead to episodes of high volatility, low liquidity, and increased systemic risk in the markets.
I put my jeans on one leg at a time and I invest in the same markets as everyone else and they are increasingly correlated. So my picks took a bath on Friday because of new concerns about the G20 achieving nothing, and China and the Euro periphery countries facing crisis. With one exception.
Chinese stocks fell the most since August 2009 over fears that the government may increase interest rates. Shanghai fell 5%. Then fears about the Irish Republic's debt walloped markets some more. The European version of the Fed, the European Central Bank, appears to be the only policy maker able to prevent the spread of the Irish and Portuguese bond market crisis. But it will have to ignore or overcome German resistance to a bond-buying program for sovereign assets as the premium investors charge to hold Ireland and Portugal debt over German hits record highs. The euro also fell to a 6-week low against the dollar.
As with the Greek crisis last spring, the longer the ECB delays the costlier intervention will be.
The China "herald of doom" which took down global stock markets on Friday was the specter of inflation. Here is the view of Asia hand Michael Kurtz of Macquarie Research on what it all means for stock market sectors:
China may still be only in the early innings of this inflation cycle. China's 2006-2008 inflationary episode provides useful data to assess potential stock implications. Inflation the last time around 'helped' A-share companies' gross profit margins in the cycle's early stage (2006-07), while hampering margins later (2008). But different sectors exhibited different characteristics:
Inflation victims: Oil & Gas, Utilities, Steel, Non-Ferrous, and Auto. These sectors suffered from margin squeezes during the entire inflation cycle, due to overcapacity (Steel, Non-ferrous), government-controlled selling price (Oil, Utilities), or incomplete pass-through of costs (Autos).
Steady margin gains regardless of inflation: Consumer Discretionary, Health Care, and Real Estate all benefitted from the dominant trends of urbanization and social safety-net reform. Within Discretionary, home appliance gross margins increased from 1.3% in 2006 to 5.3% in 2009. Financials: look at net margin. From this perspective, securities companies and Insurers fit the 2nd category (early stage beneficiaries later hurt), while Banks fit the 4th category (margin improving across the cycle).
Pure' beneficiaries: Only Coal, for which gross margin rose and fell with CPI, favoured by self-owned coal mines and a flexible pricing mechanism.
Early-stage beneficiaries/later-stage victims: Capital Goods, Consumer Staples, Info Tech, Transportation, Chemicals, and Telecom. These benefited from increasing demand during inflation's early stage while costs lagged due to old inventory, contract prices, and/or belated salary increases.
While Kurtz thinks real estate survived the earlier inflationary period without suffering, this time Beijing's “administrative” property market interventions may boost Chinese A shares by reducing property's attractions as an inflation-hedged savings alternative.