The Top 10 Reasons For Surging Asset Correlations

Tyler Durden's picture

"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

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Cheyenne's picture

I don't think the elections will change jack shit.

As Denninger points out, no one is running on a platform of hard jail time. William Black shouldn't be a figment of capitalist mythology, but yet...

Id fight Gandhi's picture

I don't invest with elections either. Its like saying stocks go down In sept.

StychoKiller's picture

Maybe so, but after being on the Tilt-a-Whirl (TM) for 10+ years, solid ground and stasis might just be what the doctor ordered.

rosiescenario's picture

" 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."

Excellently said. The true purpose of the markets is to provide an allocation of capital to either newly emerging companies or existing ones that need cash to grow new products and markets. The purpose of the market is not to create a playing field gamed by a bunch of computer geeks employed by Goldman and others.

Glass Steagall's picture
Can you tell me just WTH is wrong with an algorithmic trading program? Goldman Sux ain't the only show in town as far as these programs are concerned. Do they not bring liquidity to the market?
Minion's picture

Actually in the long term, they siphon it off, if you really think about it - skimming profits 24/7, removing it from the traditional investors who provide the long term capital.  When the traders eat the investors, can a market really function?  Said another way, when the lions eat all the buffalo, what happens to the ecosystem?

Glass Steagall's picture
But we're not talking theoretic trading. Investment/risk capital is entering the market to give the trader/investor their stake in the game. There are losses. Lions do get trampled by the herd. So do you ban bots? Is that even possible? Can that bell be un-rung?   I will have to ponder your argument though.
Justibone's picture

Let's explore the predator-prey relationship a bit.

Every non-photosynthetic species on the planet is a predator of something -- rabbits eat broccoli, for example -- so to further this comparison let's go towards aphids and leaves instead of lions and buffaloes.

If the aphids (HFT) are moderate in number, and they are the only rein on the population of plants (carbon-based buyers and sellers), then the number of leaves multiplies.  With plentiful food, the aphids multiply as well, however now they are a more effective 'check' on the population of plants.  The ecosystem will reach it's carry capacity for plants (limited soil, moisture, sunlight, etc.) and shortly after that the aphids reach their capacity.

Unfortunately for aphids and plants, the aphid capacity begins to interfere with the plants' survival.  The plants begin to die off due to excessive injury from aphid predation.  Fewer plants means more aphids either not reproducing or just dying off from lack of food.  Eventually the plants come back, which means the aphids come back, which means the plants die back, which means the aphids die back, etc., and so forth ad infinitum (so long as there is not a disruption, such as a superior competition strategy on one side or the other).

Both populations can be considered sine waves about 1/4 a rotation off of each other.  If that is the case in the current situation, then the "plants" are dying back and the HFT's will be next... but they'll be back after the carbon-based comeback.

Unless there is some sort of evolutionary development (rules change, technology advance, etc.)

I guess we'll see!

Minion's picture

HFT can provide liquidity (lots of it) if it is in the form of buying weakness and selling strength, like the market makers.  You can make a consistent profit doing this.  But if it is in the form of front running, arb strategies or any other trend following system, it's just a high powered form of price chasing and not being left holding a bag.  My own personal strategy is to collect the bait that option writers place, once it becomes clear that their expiry trap will malfunction.  Selling options is another form of predatory trading, looking for a greater fool, which is why they say 75% of them expire worthless.  :)

doolittlegeorge's picture

the election is probably the scariest prospect of all...although "at least it's an off year jobby."  some questions you ask are simply unanswerable (hence the rise of index funds) because the information is so astronomically varied and complex only God himself could possibly understand it.  There of course is nothing wrong with prayer as even "hammerin' Hank" attested to (and still does btw.)  There's a good reason why nearly all the great titans of finance who "crossed over" into the realm of policy not only kept God alongside but recommended Him afterwards as well.  It is an oh so apparent lesson of this administration since day 1 insofar as economic policy is concerned.  nothing like waking up and realizing "we never had one to begin with" right?

Oracle of Kypseli's picture

The Phoenix must burn before it rises anew from the ashes.

Prepare yourselves and keep living normally.

pitterrier's picture

Huge Republican win in November is priced into the market.  Anything less than that is going to disappoint.  What isn't priced in, is how difficult it will be to deal with the massive government that is fully entrenched and just waiting to mess with the incoming newbies.

StychoKiller's picture

What isn't priced in, is how difficult it will be to deal with the massive government that is fully entrenched and just waiting to mess with the incoming newbies.

Given enough gridlock, Govt Bureaucrats might just find themselves working for free for a change!  Through no "fault" of their own, you understand.

soliton's picture

Some believe that SPY should be at 800 and some at 1200. The first group ain't buying, the 2nd - ain't selling. So the price can be anything in between. Lite trading and here we are.

This no direction stock market will kill a significant portion of Wall Street and hedge funds. And this is a good thing. Things definitely need to get worse before they can get better.

QuantumCat's picture

Blathering conjecture.  The market is as the market does.

Correlation of markets means one thing... it is all a dollar trade.


The dollar is about to get very valuable or very worthless.  So choose your fate and pick your side...

What_Me_Worry's picture

Sorta OT: The prices paid for US eagles tonight on Ebay are out of control.  I just saw a 1/2oz. regular eagle(not a proof/COA or anything special) go off in a bidding war just north of $1,000!  1/4's are going for $400+.  1/10's are $160+.

Granted, the major online bullion dealers haven't moved their pricing more than just a touch this past week.  However, Ebay tends to show the buying tendencies of the "little guy" that can't buy in $10k+ increments.

StychoKiller's picture

These kooks need to google for better online gold outlets, like ApMex or, for examples.

RockyRacoon's picture

...there are so few investment classes that actually benefit from lower prices.

Are we so sure that this is true?


...after peaking in 1929, the DJIA fell sharply to less than a quarter of its peak value. Gold, because of its fixed price, was unaffected. Silver fell too, but it significantly outperformed the reported DJIA on the way down. What is also encouraging is that after the deflation bottomed in 1932-1933, silver bounced back quickly, and by 1934 it was higher than its 1929 level. Intriguingly, gold seems to parallel this with its repricing to $35/oz in 1934. This seems to suggest that even after a very tough pre-Keynesian (deficit spending) deflation, the bounce back significantly helped the precious metals. With modern economists already pointing to the money presses as the best medicine against deflation, any postdeflation precious metals bounce is likely to be more vigorous.”

jeff montanye's picture

and check out the performance of gold stocks after the initial '29 crash:  basically a bull market with little significant pull back then a rocket ship after the '32 bottom for another three or four years.

cocoablini's picture

The indexing comment is interesting- we can see that the average 401 k investor is complacent and got their asses handed to them in 2007-08.
Nobody wants to do research- they just want the 30 year bull market with easy money coming. Like Warren Buffet, he can say he is a maestro all he wants but he took Dads money and put it in stocks like everyone else- and rode a 30 year equity ramp. Who didn't make money?
So, the fantasy that brokerages and banks spew- that stocks make money over time historically, is a crock. We all know that the stock markets lost money inflation-adjusted since 2000. It's part of that whole index/ stocks as inflationary fantasy to sucker retail in. I ain't buying.

Budd Fox's picture

N.3 is BS.Huge B U L L S H I T

The construction of profits with a continous cut of workers benefits and the ultimate result of shipping out outsourcing the jobs is the problem...not the other way around. When you have underemployed large strata of the population, the only way you keep them consuming your crap is inflate asset prices they pledge as collateral for insane debt....and this should have been clear now.

Don't come up again with the banksters crap that restoring partially some of the benefits to the working people or regulating the fekkin TBTF will make you "uncompetitive" on a "global Scenario" or pitch and fork and tar and feather are ready for you too Mr. bootlicker of BofNY!!

BobPaulson's picture

Now is that "wax" or "whacks". Never quite caught that in Karate Kid.

laosuwan's picture

sunrise is highly correlated with roosters crowing

RighteousRampage's picture

The best thing that can be done to level the playing field, imo, is to implement a clocking system that only allows trades to transact within certain intervals, say, every 1/10th of a second or so.  So long as each trading network were synchronized against a highly accurate reference clock, there wouldn't be any arb potential, and this would diffuse the colocation arms race. 

Not sure why no one has proposed this yet. 


Captain Willard's picture


This is a very interesting idea. I hope you will post it more widely to get more comments on it.

Of course, the people with "sunk investments" in colocation won't like it.

hugolp's picture

During periods of slowing economic growth, central banks lower interest rates. That brings down the cost of capital and spurs investment and hiring.

And this is, my friends, how you create a bubble.

I hope one day we'll really learn central planning does not work.

hooligan2009's picture

and to put the cream on the cake of central bank group think..

check this out

51 pages of how central bankers all manage policy the same way and still can't explain whatdifference they make.

hooligan2009's picture

other than mean reverting every piece of profit to zero +/- 2%

anvILL's picture

I'll add the 11th reason.
People like myself who has invested using fundamentals for a very, very long time who had enough of this irrationality and started to program their own arbitrage bots.

I call this current state the "fundamental insignificance of fundamentals".

Miss Expectations's picture

"...equity markets do run the risk of becoming a rodeo with no riders."

So, here's the video of riders being thrown off the bulls.  Note that the strap around the hind end of the bull is wrapped around the bull's testicles to make him jump.  They pull it tight right before they let him out of the shoot.

buzzsaw99's picture

2) Could be boiled down to: The puppet central bankers screwed the pooch 2003-2007 on orders from their owners.

hooligan2009's picture

we are their owners! how on earth do they get put in their posts? there is no central bank qualification (even PhD's) to measure when a central bank has ever been succesful!

Hot Shakedown's picture

Off Topic: Hopefully, there is still time to get people to pay attention and effect change at the state level -- then federal. This is not about  right wing - left wing or conservative - liberal.

It is about how the people of this country are about to be fuc*ed again by the international banking cartel that curently controls the "quantity of money" in our debt based system. We need to go back to the original, government contolled sytem WITHOUT fractional reserve lending and do away with the current (privately controled) "Federal" Reserve system that is creating and forcing the US (and world) into another depression.

This video highlights the ORIGINAL symbolism seen in Baum's "the Wizard of Oz" which has been surpressed. It is a fascinating history of monetary - banking system beginning with pre- Ceasar Rome (in brief) leading to Henry I, son of William The Conqueror,  thru 17th century -- then focuses (majority of film) in the US from 16th century - present.   MUST SEE. 1 hr 51 mins. -- it will change your perception of everything. Released 1 month ago.

AccreditedEYE's picture

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.

Yes sir, that is correct. This is 1 piece in the Cabal's trinity of deception... FALSE reported numbers and accounting gimmick to distort true fundamental valuation, FALSE market demand substituted by computer programs gaming pennies with a long term holding period of under a second, and lastly, FALSE transparency through dark pools. With so much effort to be deceptive and to deceive is it any wonder we have a broken market?  

Dollar Bill Hiccup's picture

Add to the list the Agency / Principle problem. See John Authers from the FT.

If it's not your money, then lever it up and punt. We saw in 2008 that most Hedge Funds are simply levered beta. Include most Investment Banks / Brokers. Pile on the momentum, whatever is going up. Oil at $140? No problem since the boys at GS put a $200 target on it ...

Stan O'Neal alone lost $60BN. He was highly correlated w/ Dick Fuld, Jimmy Caine, Chuck Prince, etc.

Grand Supercycle's picture

Short signals detected yesterday have now increased.

Navigator's picture

I'll see your short signals and raise you a POMO day tomorrow, Friday.

Minion's picture

You raise an interesting point.  If the FED is pumping the index (in price an in the news), yet openely stated that they expected to exit their MBS positions as well as GM, will they really be the last ones holding the stock certificates?  It seems the "conventional wisdom" is "don't fight the FED".  I believe this was true in the days of natural demand for stocks by the public.  In light of capital out flows, mutual fund closings, and the flight to junk bonds, will that strategy still work?  Bullish sentiment is at an extreme, yet the whole "POMO to the sky" is absurd.  Despite all this injection, the indexes are going sideways. 

The line of least resistance appears to be down.....

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