A Simple Strategy For Reducing Losses In A Down Market

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Includes: EPD, LINEQ
by: Elliott Gue

Rising correlations have been one of the most powerful trends underway in global markets over the past 18 months. Correlation is simply a measure of how closely the prices of two stocks or indexes follow one another. If a stock is 100 percent correlated with another company's shares, the two securities rise or fall in perfect lockstep.

Stock-pickers thrive in periods of low or falling correlation. When stocks move in different directions, traders can reap huge potential gains by buying the winners while avoiding or shorting the losers. By contrast, when all assets move in a similar direction, it's tougher to beat the indexes.

"Rising Correlation" shows the correlation between various S&P 500 economic subsectors and the index itself-the higher the percentage, the more closely the sector indexes track the S&P 500. As you can see, correlations were relatively low in 2004-06. For example, the S&P 500 Energy Index was only about 50 percent correlated to the S&P 500, implying that many individual energy stocks bucked the trend.

Correlations have increased dramatically across sectors since the beginning of 2011. This is another symptom of the "risk-on/risk-off" trade that you hear so much about in the financial media. When investors grow worried about the macroeconomic picture, they sell off their holdings as a group-energy stocks are sold alongside industrials, retailers, commodities and even high-yield bonds. When the news brightens, all stocks tend to rise as a herd.

Despite rising levels of correlation, there are reasons for optimism. Periods of unusually high correlation inevitably come to an end. As we progress through 2012, the macroeconomic picture should begin to clear. The EU will ultimately resolve the sovereign- debt crisis, and political uncertainty in the US will abate after November's presidential election. Uncertainty will gradually give way to calmer and less correlated markets.

Even in highly correlated markets, some sectors offer more diversification from broader market trends than others. Telecommunications, consumer staples and health care are three less-correlated sectors (see "Rising Correlation").

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Income-oriented stocks feature a less-than-average correlation with the broader market than growth-oriented stocks. For example, the Alerian MLP Index, a benchmark for master limited partnerships (MLP) that includes Enterprise Products Partners LP (NYSE: EPD) and Linn Energy LLC (NYSE: LINE), is only about 65 percent correlated with the broader market averages. MLPs offer a winning combination of yield and relatively low volatility.

It's impossible to completely insulate your portfolio from vicious swings in the broader market. But diversifying your holdings to include stocks and sectors that are less correlated to every turn in global markets can reduce paper losses. That's one reason that health care and consumer staples rank among my favorite sectors.

Disclosure: I am long LINE, EPD.