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December 12, 2011

Record High Correlation: Markets of a Direction Crash Together?

By Cyndi Laurenti

As 2011 comes to an end, investors, and analysts are taking a closer look at the patterns of high correlation in the financial markets that have taken shape during the year. The observed correlation has been the highest since the infamous Black Monday stock market crash of 1987. But according to money managers attending the 2012 Reuters Investment Outlook summit in New York this December, high correlation may be coming to an end.

The money managers at the summit aren’t alone on this view.  An argument often-mentioned when discussing correlation is that it usually occurs during periods of economic turbulence.  Since 1998, the correlation between different financial exchanges in the United States has come to mirror conditions seen in Japanese markets.  American equities, commodities and bond markets have shown similar trends (see chart below added by EconMatters). Typically, equities and commodities tend to have a negative correlation to bond market.  That is, when the yield of the 30-Year Treasury Bill falls, equity and commodity markets  tend to rise and vice versa.

Dow, SP 500 and 10-year Treasury Yield Comparison 

Chart Source: Yahoo Finance, 11 Dec. 2011 (Added by EconMatters)

An article published by The Economist in 1997 in the wake of a Wall Street near-crash cited a research study that showed an average inter-market correlation of 0.5 percent among the world’s nine largest economies, meaning that whenever the American stock markets rose by one percentage point, the markets in the other eight economies would also rise by 0.5 percent.

That same article cited an opinion by a Goldman Sachs economist who argued that the world’s markets only become correlated in times of global prosperity; a statement that was disproven by the correlation of markets during the current global financial crisis. The crux of the article was that unless two stock market indices –like the Dow Jones Industrial Average and the S&P 500- continuously move in the same direction and their sizes remain relatively equal; investors should diversify their holdings as a hedge against absence of correlation.

In September 2011, The Economist took a slightly different view of diversification. Thanks to the phenomenon of globalization, correlation of the world’s financial markets has become more prevalent. According to the new article, the global herd instinct is now more pronounced than ever, thus reducing the likelihood of independent behavior among the world’s stock exchanges. Fundamental economic factors are being ignored in favor of short-term performance, particularly in the equity markets. Logical thinking implies that, given the economic conditions, the stock markets of emerging market economies in Latin America and Asia should be outperforming the North American and European exchanges, yet that is not the case.

The diversification mantra preached ad nauseam by money managers and advisers might be to blame for the high correlation observed in the markets over the last decades. Individual and institutional investors have followed the diversification advice for so long that their portfolios are remarkably similar. At the Reuters Investment Outlook summit, investors are predicting that high correlation can no longer be sustained, therefore a correction is expected as fund managers test the waters and become more creative. This will entail taking chances and breaking away from the diversification norm in order to reap higher returns.

Not everyone shares the opinion of the summit attendees. A recent blog post in the Wall Street Journal explained that investors are now essentially locked into a certain reaction pattern every time central banks enforce liquidity measures. The CBOE Implied Correlation Index, a barometer used to measure traders’ correlation expectations, is at historically high levels. As long as investors keep taking market positions in unison, high correlation is likely to prevail.

Courtesy Cyndi Laurenti at Business Degree - While she figures out her next career move, Cyndi works as an online writer and editor. Her primary interests are education, technology, and how synergies can be created between the two for social good.

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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