"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.
3) Heavier regulatory/taxation overhang. Chief executive officers like certainty. There isn’t much around in the best of times, including the security of their own jobs if things go awry. The U.S. has seen two large-scale pieces of legislation passed – financial services regulatory reform and health care – since the 2008 financial crisis. No matter where your political leanings may be, it is easy to see how +4,000 pages of new laws might put a bit of a chill in the C-level office suites of the country’s large companies and outright fear in the kitchen offices of small businesses. When combined, the two new laws touch both access to capital and labor cost structures in ways even the most politically connected enterprises on the planet– multinational banks – have trouble quantifying.
Those fears create higher correlations across financial markets because, as with the prior point, they tear up the traditional “playbook” for economic recovery. Companies are especially reluctant to hire new workers since they worry about what incremental health care expenses may be associated with this hiring. Combine that with shaky final demand in many sectors and it should come as no surprise that unemployment is so sticky. Financial regulatory reform faces another round of headline-grabbing uncertainty as the new Consumer Financial Protection Bureau kicks into gear. Can banks fulfill their key role in the U.S. economy when regulatory uncertainty litters the front page? It seems a tall order.
4) Globalization of economies and financial markets. There is an old saying to the effect that “data is not the plural form of the word anecdote.” Still, the financial crisis yielded a rich trove of stories about how the meltdown in the U.S. housing market touched everyone from Icelandic herring fisherman to Maine’s lobster business to Norwegian pensioners to Chinese factory workers. There can be no doubt that the world’s economies are more closely knit together than ever before.
Geographic diversification is one important access point for investors to buy less-correlated assets. Economic co-dependence may yield benefits from trade during good economic times, but it also increases the correlation of financial assets across the world’s markets.
5) A still fragile U.S. housing market. Most Americans own their primary residence – something over 66% of them at last count. But for +90% of them – maybe even 99%, we suspect – their house is also their largest financial asset. House prices therefore drive a lot of most Americans’ “wealth effect’ – the portion of their spending that is driven by how well-off they feel rather than how much they make.
Prior to the 2008 financial crisis, house prices had not gone down on a national basis since the 1930s. That rubric was the intellectual anchor for much of the stupidity in the housing market during its bubble. Even with the pullback in residential real estate prices since 2007 no one can be sure that the troubles are not over for this market. That is yet another reason why the domestic recovery has been sluggish and choppy. And yet another reason why markets tend to correlate, as the domestic consumer is responsible for 70% of the economy. When one input – house prices – can swing consumer spending patterns for much of the economy, it is understandable that many stock market sectors will behave similarly.
6) Worries over deflation as an existential threat in the US. Central banks around the world know how to fight inflation. Raise interest rates, cool the economy, and watch expectations for inflation fall. If there is an “Easy button” in the central banker’s toolbox, this is it.
In contrast, there is no effective playbook for deflation. Theories, yes. Plenty of those. Drop money from helicopters, to borrow from Fed Chairman Ben Bernanke’s oft-quoted speech. Japan, which must have more monetary policy helicopters than the world’s armies have real ones, is proof that deflationary expectations are pernicious and much harder to beat back than inflationary ones. Oh, and don’t tell me that deflation is not a realistic threat just because of the acres of cash hovering around the banking system. If it were not, why would the Fed be talking up the possibility of another round of quantitative easing?
That lack of a recognized “cure” for deflation causes higher correlations because there are so few investment classes that actually benefit from lower prices. Sovereign debt is pretty much the only item on that menu, even as the credit-worthiness of most developed economy issuers is the lowest since World War II. All this contributes to the “twitchiness” we have noted in other points here since deflationary environment is not usually a good one for most risk assets. Just look at Japan.
7) Structurally higher US unemployment. Past U.S. recession – think 1973/4, 1979/80, 1982, 1990, and 2001/2002 – saw quick spikes in unemployment followed by a gradual but perceptible return to more normal levels. Auto workers are laid off when demand drops, for example, and then called back in 6-12 months as demand recovers.
This time the contours of the recovery in labor markets are more difficult to predict. Much of the drag seems to come from the persistently high unemployment among less-educated workers, where unemployment rates are all higher than national averages. The U.S. has a clear surplus of construction workers and a clear shortage of affordable software engineers. It seems unlikely that workers can migrate from one vocation to the other, however. Capital markets are all-too-aware of this problem and cognizant of the fact that this means structurally higher unemployment, a sloppier recovery and greater risks to another economic downturn. And all that means, as with so many points outlined already, a “twitchier” hair trigger sensibility to investing in risk assets.
8) Memories of recent financial markets turmoil. Clever market watchers have called this the “Jason Bourne” market, because you don’t make an investment without first planning several exits in case your expectations don’t play out. That’s a hard to quantify observation, but neatly encapsulates the skittish “risk on, risk off” nature of the markets.
9) High frequency trading. By most widely quoted estimates, high frequency trading is some 60-70% of all daily activity in U.S. equity markets. HFT is a catch-all name for a range of strategies, from ETF arbitrage and statistical arb to trying to sniff out and front run large orders. But what almost all HFT trading has in common is a studied ignorance of company and sector fundamentals and an effort to allocate investor capital along those lines. And the few strategies that do still only hold stocks for a fraction of the time usually required to close the gap between aberrant perception and reality.
HFT doesn’t add correlation as much as it seems to drive money away that has historically put money to work in less correlated methods. Retail investors have fled actively managed U.S. equity mutual funds since the “Flash Crash” of May 6th. How much of this is due to the volatility of that day is impossible to know. It does not seem to be performance driven – U.S. stocks are up on the year and essential flat from May 6th.
Those who know far more about HFT than I do say “You cannot turn back the clock on technology.” Fair enough. But when technology becomes the end rather than the means it should be no surprise that other market participants will pack up and look for greener, less trampled pastures. And when those market participants are the ones that are better equipped by virtue of fundamental research and investment horizon to set rational prices, equity markets do run the risk of becoming a rodeo with no riders.
10) Upcoming U.S. elections. We’ll close out this list on a note of optimism. The entire House of Representatives and 37 Senate seats are up for grabs in a few weeks. If the primaries are any guide, there will be a lot of fireworks on Election Day 2010. No doubt the market is waiting to see the outcome of this event. Gridlock by dint of a Republican win in the House will almost certainly bring some change to Washington. Markets, like those CEOs we mentioned, like certainty – even if certainty means “nothing done.” And that could be enough to begin the thawing of corporate confidence and a more “normal” playbook for economic recovery.
Source: BNY ConvergEx