Adreno's  Instablog

Past few weeks the mainstream media and SA authors barraged the message of rising correlations. This media mania culminated in the WSJ asking "is stock picking dead?" The question would be appropriate in the context of market efficiency. But in the context of increasing correlations it is just ludicrous. When everything is bought or sold in blocks, stock prices detach from fundamentals and the magnitude of mispricings increase. Stock picking becomes more profitable, not less. (That is if you are adept at stock picking to begin with, most of us would be better off just buying an index fund.)

In the 20th century stocks were held for years on average. Low-cost internet trading and technical analysis reduced the average hold time to months. Then came High Frequency Trading and according to some, the average hold time for stocks is now measured in seconds. In the course of a century, we turned from long term investors to short term speculators. To find some solace, at least this casino has positive expected value for players who take long positions.

To me the most fascinating question is always "why?" In this case, why do people believe a temporary situation is going to last forever? I believe the answer lies with our short term orientation. We tend to extrapolate recent history into above & beyond. If we looked at the weather like we look at financial markets, we would be surprised every time the summer turns into a winter (car owners repeatedly are). I guess some confusion is warranted since financials don't move in clockwork like the 4 seasons. I don't know when correlations will come down, but I bet you they will. Correlations usually rise during major crises when people focus more on the big picture and less on individual companies. After crises correlations come down. You need pretty good arguments to convince me that "This time is different".

Some reasons suggest higher correlations are here to stay:
#1 - The world is more connected. Most major companies have international operations and there is so much international trade that economies are more dependent on each other. In 2008 the U.S. financial crisis turned into the global financial crisis. In 2011 the Tunisian revolution caused uprisings in 17 Arab countries... to date.
#2 - Popularity of ETFs and mutual index funds have shifted trading from individual stocks to entire markets.

Despite these valid arguments, lockstep correlations are going to disappear. A successful company is still worth more than a bankrupt one. If stock prices will forever move in lockstep with each other, then the fortunes of all companies must move in lockstep. Elecster is a Finnish company that packs milk in Europe. What does Elecster have in common with Toyota? If people stop driving Toyotas are they also going to stop drinking milk?

In conclusion, I think correlations will be higher this decade than they were 2 decades ago, but they will be lower than they are right now. Value investors can exploit high correlations by buying stocks that are sold off to unjustified levels. If you want good risk adjusted returns, you still need to diversify. Note that some crucial aspects of diversification are not uncovered by fancy mathematical models.