Are Rising Correlations a Threat to Your Portfolio?

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In the brave new world we inhabit,everything is interrelated. 

The butterfly effect has grown exponentially.

When Cyprus sneezes the rest of the world catches a cold.  When the ECB speaks, the markets around the world stop to listen. 

Put another way, U.S. investors must care whether or not tiny countries on the other side of the world will have an impact on their portfolio. 

Traditional finance theory suggests that the more eggs you put in your basket, the less likely it is you will be adversely affected by an isolated event.  The more diversified, the lower the risk.  But I am not so sure anymore.

Causation or Correlation? It Doesn't Matter Either Way
Take a look at the correlation chart below.


It is hard to argue whether you own U.S. domestic stocks or European equities the results would be much different.  With a correlationapproaching .90, for all intents and purposes the U.S. and European stock markets (NYSEARCA:VGK) perform very similarly, to a point of almost being indistinguishable. 

This affects you many ways,but here are a few of the adverse potentials:

--Having a diversified portfolio may actually be doing you a disservice because of the increased transaction costsin maintaining a diversified portfolio. The bang for the buck just may not be there.

--Your portfolio is probably not nearly as protected as you or your financial advisor thinks. Why? Because correlations gravitate during sharp market declines, causing diversification to fail just when you need it most.

--Traditional portfolio analysis typically overestimates correlations during good times and assumes wrongly they will persist when markets decline.

The new highly correlated paradigm trickles all the way down to individual stocks. Do individual company earnings per share ( EPS ) really matter any more? The macro environment has become so interrelated that individual stock picking is not nearly as effective as it once was. Stocks - both bad and good - rise and fall together.

"To be diversified, which means that returns on your assets don't move up and down together, you have to think very hard. Today, if you own stocks of various countries, particularly American and European stocks, you're diversified in terms of currency exposure but you're really buying the same merchandise. They'll tend to go up and down together," once said  Peter L. Bernstein, founding editor of the Journal of Portfolio Management and author of several books, including Against the Gods: The Remarkable Story of Risk. "The main point is to avoid being wiped out if something happens to your main asset holdings."

Rising Correlations Elsewhere 
Many investors may not seethis as an issue, because equities generally always had a high correlation with each other (not this high, though).

A major concern now though is that high correlations have also shifted not only among assets of the same class, but among asset classes themselves.

Today, Oil (NYSEARCA:OIL), gold(NYSEARCA:NUGT), housing (NYSEARCA:XHB), and currencies (NYSEARCA:FXE) all have a significantly higher correlation with each other today thanthey did historically.

What to Do About It

One way to find a littlecomfort with this big issue is to embrace it. Here is an example.

On 4/24 in our ETF Technical Forecast we provided the following chart and identified how to take advantageof the high correlation between the U.S. and European markets.  "A breakout of the upper range of the flag pattern shown in the chart below would constitute an aggressive buy signal.  A breakoutof the European markets also likely means a continued rally for the U.S. equity markets (NYSEARCA:VTI)."



We were able to suggest buying VGK at $50.50 on a breakout.  Since then it hit our 4% profit target a week later at $52.50, and we have moved our stops up accordingly.

If Europe broke out, it was safe to assume the extremely high correlation would hold, and therefore the U.S. markets would also move higher.  They of course also did.

A Little Sweet with aLot of Sour

One positive of the extremely high correlations among equities is the clues we canget from their relationships, as we did with our recent trade.

ETF Profit Strategy Newsletter


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , ETFs

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