Guest Post: "As Implied Correlations Approach 100%, Energy = Healthcare = Technology = A Rat’s Ass, Etc. "
From John Lohman
A hedge fund manager/friend of mine recently described forces driving the market as “barely manned scrip cannons.” Unfortunately, I believe it’s a fairly accurate description of the HFT-ETF-Algo driven cluster that used to be a market for financial assets. Individual investors have lost confidence, voted with their feet, and left us with a single asset. It comes with a put option underwritten by the federal government and its value fluctuates in response to barely manned scrip cannons.
For perspective on how this is impacting macro markets, consider the chart below. It plots the average one year rolling correlation of various markets with the S&P 500 Index. In short, a currency = a yield = a commodity index = a unicorn, etc. Completely different assets with completely different cash flow streams and terminal values are apparently fungible.
This phenomenon can also be seen within the equity market. Zero Hedge has pointed out the absurdity of the level of implied correlations several times. This chart from Barclays provides some context. As shown, the trailing one month cross-sectional correlation for the largest 1,000 stocks averaged roughly 20% for the last half of the 20th century. The remaining variance in prices would be explained by the fundamental factors within each sector, industry, and firm.
But in today’s environment, idiosyncratic risk doesn’t exist. As implied correlations asymptotically approach 100%, energy = healthcare = technology = a rat’s ass, etc.
This is the unfortunate result of markets where governments and central banks try to truncate risk and algos determine marginal prices based on short-term patterns. In the real economy, price signals have become distorted, thus causing capital to be inefficiently allocated. In the financial economy, the environment has become riskier than ever. The farther prices are pushed away from their true underlying value, the greater the adjustment will be. And one thing the algos don’t do - adjust slowly.