In the brave new world we inhabit,everything is
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
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
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
--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
--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 (
) 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
"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
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
A major concern now though is that high correlations have also
shifted not only among assets of the same class, but among asset
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
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