Correlation

Drawn into the stream
Of undefined illusion
Those diamond dreams
They can't disguise the truth
--Level 42

The capital asset pricing model (CAPM) focuses attention on reducing non market (or security-specific) risk by managing the 'beta' content of a portfolio. However, this approach does not address market (or systemic) risk. This is the risk that is shared by all positions in a portfolio.

Degree of market risk can be estimated by examining the correlation between portfolio components. The higher the correlation between components, the more they move together. Higher correlation suggests higher market risk.

Data suggest that correlation between risky assets has been increasing for years.

First, check out the average correlation between components of the S&P 500 (blue bars). Correlation between S&P 500 stocks has about doubled in the past decade.

Next, the Russell 2000 (blue line). Once again, correlation has about doubled in the past 10 years. Note that the internal correlation of the Russell is higher than the internal correlation of the S&P.

What about foreign stocks? Below we see the correlation between the S&P 500 and the EAFE (Europe Australasia Far East) Index. Once again, we observe a steady march higher in correlation. The correlation between the S&P and the EAFE current stands at a stunning 0.9!

One historic attraction of commodities and other hard assets has been their negatively relationship with stocks--which has made them good diversification vehicles. That attraction has been waning. The gold line below shows the average cross correlation between various asset classes including S&P 500 stocks, gold, oil, 10 yr Treasury rates, and various foreign exchange (forex) cross rates. Prior to 2005ish, these cross correlations were indeed negative. Over the past few years, however, correlations between broad asset classes has turned positive--and the relationship appears to be increasing.

An important question you should be asking is why--why are correlations increasing among risky assets?

In any event, results suggest that, when investors are long risky assets, they are taking on ever greater levels of market risk.

position in SH