One of the parallel consequences of the market plunging (although nowhere near as far as it would had central bankers not be ubiquitously present to cushion every blow) in the past month on fears of another Great Financial Crisis, coupled with concerns of global insolvency, has been a surge in stock correlations (if not so much between stocks and other risk assets such as bonds and gold), to the highest point since the Lehman collapse. Putting a number to the "point" - 97.2%. Here is how BNY Convergex' Nicholas Colas summarizes the recent surge in cross sector correlations: "Disparate markets – stocks, bonds, currencies, and the like – have a lot in common lately. Whether they want to or not. Average correlations between the 10 major sectors of the S&P 500 have reached 97.2%, from 82.1% just three months ago. That’s the highest level of such common price action since the Financial Crisis. Gold and silver have continued to provide actual diversification, and Investment Grade bonds are also holding their own in this regard. They are at least moving on their own, rather than lockstep with the rest of the world. The difference between investing in Emerging Markets equities, Developed Markets equities, and High Yield bonds is now effectively zero. We think these high correlations will plague markets through the end of the year, since they are fundamentally caused by worries over European financial market solvency. Those aren’t going away any times soon." Well, they might, if someone actually believes the lies spewed by European bankocrats, who have now reached new lows in dealing with information, by sicing regulators against those who write OpEds. Very soon the dissemination of facts will also be made illegal, but until then, we will likely see correlations continue to trade, and soon hit 1.000 as everything trades in perfect lockstep with every other robot traded "thing."
- U.S. stocks seem to be walking the picket lines in front of the capital markets, chanting in unison. Well, not literally, of course. But just look at the correlations between the 10 industry sectors of the S&P 500. At 97.2% average correlation, U.S. stocks are moving in lock step to a degree we haven’t seen since the depth of the Financial Crisis. This is not the normal course of business, to say the least. More commonly, some stocks go up while others decline.
- Many other asset classes are apparently siding with stocks, and moving alongside them – sort of a sympathy strike. These include High Yield Bonds (which have many equity-like financial characteristics but are, ultimately, not stocks), the Australia Dollar, and developed as well as emerging economy stock markets.
- The only assets that still have some independence left in them – call them the rugged individualists – are gold and silver. These precious metals still show negative correlations to stocks (negative 55% for gold and negative 35% for silver).
This trend has been forming for months, so I have had some time to consider what might be going on. Here’s my brief take:
- The correlations we note among industry sectors are profoundly and dysfunctionally high. They come, in my opinion, from the underlying concern over a second financial crisis caused by the default of Greek or other European sovereign debt and the resulting stress caused to the financial system. The only reason it won’t matter whether you own utility stocks or tech stocks or health care stocks is if the world’s major banks can’t open for business the next day.
- Stock markets around the world, but especially in the U.S. and Europe, are trying to fine tune this existential calculus. If there is a 5% chance of a Greek default, then where should stocks trade? OK… Now how about 10%? Now 20%? Now back to 5%? Now what if U.S. banks need another bailout because their counterparty exposure is higher than we think? You get the idea. Markets are trying to discount the survival rate of another cross-border financial pandemic. That is why they move in lock step.
- Gold and silver traders have gotten too used to the negative correlation trade with stocks. This is, in fact, an unusual relationship for precious metals to stocks. The correlation should actually be zero. You can begin to hear the frustration in traders’ voices on days like Monday, when gold doesn’t rally on a drop in the market. Here’s a news flash: it is not supposed to move opposite to stocks. It is only supposed to move independently of them.
- The stability of high quality bonds (we use the iShares iBoxx Investment Grade Corp ETF, symbol LQD, to track this asset class) in a tumultuous period has been unexpected and frankly impressive. Investment grade bonds are still up over 4% on the year, and their correlation to stocks is negative 24%. Not as inversely related as the precious metals stats I noted above, but far better than the 89% correlation to stocks exhibited by High Yield Bonds.
- If the basic thesis here is correct – that correlations will stay high as long as markets are worried about solvency more than individual stock fundamentals – then we probably have several more months of lock-step price action. And with this comes high volatility, for many of the same reasons.
And the above in pictures: