Tuesday, July 28, 2009

Is Everything Correlated?

Over the past few weeks it has become glaringly obvious to me that correlations between asset classes have become extremely high. Correlation is the statistical number that describes the degree of relationship between two variables. When the correlation is 1 then the two variables perfectly move in the same direction, and when the correlation is -1 then the two variables perfectly move in opposite directions. So, how much have correlations spiked, or moved closer to 1?

I analyzed the correlations from the market bottom on 3/9/2009 through yesterday 7/27/09. I used the S&P 500 Index as the constant for comparison (this is to represent the market) and used five other assets classes as my variables. I started with Russell 2000 Index and found a correlation with the S&P 500 Index of .98 which is a slight spike but the historical number is around .9 so that is not entirely surprising. I then measured the international markets using the MSCI EAFE Index and MSCI Emerging Markets Index and the correlation was .98 and .93 respectively which was also a slight spike from the .85 historical numbers. I then moved to commodities, REITs (Real Estate Investment Trusts) and high yield bonds to gauge asset classes with low historical correlations. Historically, these asset classes have shown a correlation with the S&P 500 of .2 for commodities and REITs and .6 for high yield bonds. However, during this last market rally the correlations have really spiked to .75, .85, and .9 respectively!

With most risk assets at extreme correlations it seems that one must decide to be in the market or out of the market. Diversification is breaking down and places to ‘hide in the market’ have diminished. If you have owned risk assets you have been extremely happy over the last few months since you have probably made a lot of money. But if this does turn and the market heads lower are you prepared for high correlations to the downside?