AAII Investor Update: Highly Correlated Stock Returns Are Temporary

Sep. 16, 2011 7:28 AM ETADBE, AZO, CAG, BBBY, GIS, KMX, FDX, NKE6 Comments
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Stock price movements have become highly correlated, with correlations reaching levels not seen since 2008. This is not surprising given historical data and should end up being a temporary occurrence.

Correlation, in financial terms, is a mathematical model that indicates how closely the returns of various assets match each other. Correlations can range from +1.0 (assets have returns that move in lockstep together) to -1.0, (assets have mirror opposite returns). Correlations may be expressed in decimal format (e.g., 0.72) or percentage format (72%).

Over the long-term different types of stocks have varying correlations. Small-cap stocks, for instance, have a long-term correlation of 0.72 with large-cap stocks, according to the Ibbotson SBBI 2011 Classic Yearbook. This means that while small-cap stocks have similar returns to their bigger brethren, they do not always move in the same direction or experience the same magnitude of change. Thus, you get some diversification benefits by combining small- and large-cap stocks in a portfolio. (Mixing in micro-cap, developed foreign market and emerging market stocks into a portfolio provides even more diversification benefits.)

Even among large-cap stocks, long-term correlations stay below +1.0 due to differences in industries, business conditions and valuations. For example, the performance of Bank of America (BAC) is affected by factors that don't directly influence Apple (AAPL) or Exxon Mobil (XOM). Thus, under calmer market conditions, diversification benefits can be realized even among large-cap stocks.

During periods of market duress and volatility, correlations move toward 1.0. This is what is happening right now. Nicholas Colas, the chief market strategist for the ConvergEx Group, calculated that "average correlations between the 10 major sectors of the S&P 500 have reached 97.2%" for the 30-day period ended September 9, 2011. This is the highest correlation since 2008's financial crisis. Coincidently, Vanguard just issued a research note showing last month's volatility in the S&P 500 as being the highest

This article was written by

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Charles Rotblut, CFA is the editor of the AAII Journal, the flagship publication of The American Association of Individual Investors (AAII). Charles provides both insight about individual investor sentiment and market analysis. He is also the author of "Better Good than Lucky: How Savvy Investors Create Fortune with the Risk-Reward Ratio" (W&A Publishing/Trader's Press).

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