Top Ten Reasons for Surging Asset Correlations

Thursday, September 23rd, 2010

“Wax on, Wax off”, “risk on, risk off”, whatever you want to call it, the most prevalent phenomenon in capital markets over the bear market rally of the past year has been the gradual yet relentless rise in cross asset correlations. As we reported earlier, hedge funds are now openly returning capital due to their inability to properly hedge positions and execute on traditional long/short strategies, which in turn is wreaking havoc on the entire 130/30 or 130/70 model (which also means gross leverage for most rational hedge funds is reduced as those who do gross up, are effectively betting the farm on market moves with an increasingly shorter and more volatile even horizon). Long before this became a daily topic on CNBC, we were warning about the dire implications of alpha extinction, and the impact it would have on hedge funds. And with the opportunity to diversify away risk increasingly taken away from investors, we expect that this trend will result in ever more capital fleeing the stock market. Yet the question remains: what has caused correlations to surge to current levels? If these reasons can be identified, it should be easy to eliminate them one at a time until some semblance of a rational market returns (at least on paper). Luckily, Nicholas Colas of BNY has once again beaten us to the punch, and has compiled a list of the top 10 reasons for increased asset price correlations. So without further ado…

1) Index-based, rather than active investing. Investing capital by index rather than stock picking is the financial version of “Why buy the cow when you are getting the milk for free?” After all, IF the stock market regularly returns +10% (which it did from the early 1980s to the late 1990s) AND most active equity managers underperform their benchmarks, then just putting money into a low-cost product that tracks a broad market index makes all the sense in the world.

What a difference a lost decade for equities should have made, but evidently didn’t. The largest Exchange Traded Fund is the SPY, engineered to mirror the S&P 500. Other popular ETF products anchor off international stock market indices (EFA, EEM, for example), the spot price for precious metals (GLD, IAU, and SLV among others), and even unmanaged bond indices (AGG, BND, and SHY, just to name a few). And, of course, many of the largest mutual funds are index-based as well. Index-based investing has only grown in popularity during the “lost decade” for equities.

The troublesome feature of this trend is that indexing makes no differentiation among companies that merit capital and those that don’t. That’s not an indictment, per se: it’s what the funds do and investors have every right to make that investment choice. But when capital flows to a company for no other reason than it is in an arbitrarily created index, the purest function of markets – allocating capital to its best possible use – will by necessity not work as well, and correlations will also tend to increase. Money that goes into an indexed product will be put to work across the board, not into the sectors and companies that offer the best risk-reward. That is the recipe for higher sector correlations.

2) Artificially low interest rates/ lack of a rate cycle. The business cycle and its interplay with interest rates is a bedrock driver of stock and other asset prices globally. During periods of slowing economic growth, central banks lower interest rates. That brings down the cost of capital and spurs investment and hiring. On the upside of a business cycle, the reverse action takes place as central banks raise rates to lower the chances for inflationary pressures to build. The rate cycle drives historically drove the out – or – under performance of many equity market sectors, including financials, consumer durables and housing.

Throw all that out the window now. Central banks in developed economies have pinned short-term rates near zero and purchased longer dated sovereign debt in order to keep rates low across the yield curve. Their economies and banking systems are just too fragile to absorb the shock of “market” rates, especially as the governments of the U.S., Europe and Japan are issuing incremental debt to fund deficit spending. But without the normal rate cycle, investors are missing cues that have historically given them reasons to rotate among different industrial sectors. That makes the traditional sector rotation of typical cycles a thing of the past, and it should be no surprise that correlations rise in the absence of a “normal” investment cycle.

Tags: Asset Price, Bear Market, Benchmarks, Bny, BRIC, BRICs, Broad Market, Capital Markets, Cnbc, Colas, Correlations, Equity Managers, ETF, Extinction, Fundamental Indexing, Hedge Funds, Market Index, Market Moves, Market Rally, oil, Semblance, Stock Market, Stock Picking, Top Ten Reasons, Wreaking Havoc
Posted in Emerging Markets, Energy & Natural Resources, ETFs, Markets, Oil and Gas | Comments Off

The Oddities of this Recession (Rebecca Wilder)

Wednesday, August 5th, 2009

Rebecca WilderThis post is a guest contribution by Rebecca Wilder*, author of the of the News ‘n’ Economics blog.

It is not a rule that the personal saving rate rises during a recession, just in this one. Take a look at the cumulative trajectory of the personal saving rate for this Great Recession compared to its predecessors, as represented by the “average recession” since 1960.

The chart illustrates the cumulative growth of the saving rate throughout the recession period and during the twenty-four months (of recovery) following the recession for the current cycle and the average over the latest 7 cycles. Note: convenience only, I call the end of the current cycle at point 0 or June 2009. I do not believe that the recession is actually over in June.

Recently, the average saving rate, which is estimated monthly by the Bureau of Economic Analysis, surged since the onset of the longest recession in the post-War era. Consequently, the sharp ascent of the marginal saving rate is wreaking havoc on personal consumption spending, and thus, GDP.

Interestingly, current saving trends mark opposing behavior relative to the “average” recession occurrence, which is the indexed trajectory of the average saving rate spanning the 7 recessions since 1959. The saving rate drops during the average recession, and stabilizes thereafter. So far, the saving rate has a -50% correlation with the saving trend during “average recession”, and is moving against the broader historic trend. If saving continues its ascent, one can discount quite significantly the possibility of an “average recovery” to a recession this deep (i.e., V).

* Rebecca Wilder is an economist in the financial industry. She was previously an assistant professor and holds a doctorate in economics.

Tags: Ascent, Assistant Professor, Bureau Of Economic Analysis, Correlation, Cumulative Growth, Doctorate, Economist, GDP, Occurrence, Oddities, Personal Consumption, Point 0, Post War, Predecessors, Rebecca, Recession, Recessions, Trajectory, Twenty Four Months, Wreaking Havoc
Posted in Markets | Comments Off