When Correlations Go to One

There haven’t been many safe places to hide from the current market sell-off. Here are the returns through the end of the day on Tuesday for a variety of markets and styles:

I’m sure there are some select strategies that are holding up during this downturn, but from a traditional perspective, bonds are really the only assets treading water.

Some people assume that because nearly all risk assets fall at the same time that markets are becoming more and more intertwined with one another. While I think that globalization and the free flow of information could potentially be speeding up market cycles, risk assets have been highly correlated during stock market corrections for some time now. This is nothing new. Here are the historical numbers that show how different stock markets and market caps have performed during past large losses in the S&P 500:

This list includes all of the double digit losses I outlined a few days ago on the S&P 500 since 1980, along with the current correction. None of these other markets have been positive when the S&P 500 hits correction or bear market territory in the past. While some like to use these types of numbers to expose an Achilles heel of diversification, I don’t think that’s the case here. What this shows is that during market sell-offs and panics investors tend to shun all risk assets, regardless of company size or geography.

These are the times when high-quality bonds or even short-term cash equivalents finally have their day and prove their worth for inclusion in a broadly diversified portfolio. They provide not only an emotional hedge but also act as the flight to safety asset class during a market panic.

The last couple of days have unnerved and surprised a lot of investors. The wild intraday swings feel like they don’t have any place in the largest, most liquid financial markets. But this type of volatility is nothing new. In early August of 2011, the last correction we’ve seen in U.S. stocks, the market had four consecutive days with returns of -6.7%, +5.2%, -4.8% and then +4.6%. That was a little less than two months before that correction ended, so the volatility was a precursor of what was to come, not an end to the sell-off.

Volatility tends to beget more volatility in the markets (in both directions) as investors start to make rushed and panicked decisions. After a number of years of relative calm, it appears risk assets are finally living up to their name.

Further Reading:
To Win You Have to be Willing to Lose
Your Very Own Black Swan Strategy