Coaker has a couple great papers on correlation and the volatility of correlation. Below are five charts that examine the one-year rolling correlations between the S&P 500 Index TR and :
Foreign Stocks (MSCI EAFE)
10 YR US Govt Bonds
Commodities (GSCI)
REITS (NAREIT)
The red line is the average correlation over the time period 1973-2008.
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That top graph's especially poignant. I remember when the financial press was espousing the supposed “de-linking” that had occurred with US equities and emerging markets…you could get both great returns AND low correlation by investing. Well, when the US economy blew up last year, these markets tumbled even worse. Note how the correlation spiked toward one. So much for the “de-linking” theory. It appears as though when all hell breaks loose in the global markets, the US is still very relevant to what happens abroad.
These charts look well co-integrated. Perhaps there is a dispersion or straight correlation trade to take advantage of???
Hi Mebane
Been a while. Wondering if you've run numbers for emerging market equities (say, using MSCI EM Index) and see how correlations have changed vs S&P 500 as well as EAFE. Many argue that emerging markets are a diversifier but I wonder. Put up a chart for the ETF EEM or VWO and overlay ETFs for any commodity producer country (Canada, Australia, South Africa, etc.) and you see that they basically overlap. Even for more robust economies like the US, the general trends are quite strong. You only have to wonder if investors have had higher commodity allocations and that may have further negated the benefits of diversification if they've held broad emerging market holdings. If true, then emerging markets are a return enhancer and less of a risk reducer. The only way to turn that around would be to either to timing positions in EEM/VWO, sector rotating within emerging markets or getting in and out of various emerging market country ETFs. Thoughts?
RCK
The fact that the correlations fluctuate so wildly must have serious implications for
your TAA model. Any thoughts?
Mebane,
since stocks are best for the long run (sometimes that is a very long time) what one wants is an asset class that complements equities ie it goes up when equities go up and it goes up massively when equities go down – there is only one asset class out of 15 that does that – managed futures.
Any thoughts on that?
I remember trying to explain this to people in the past. It was amazing how many “professionals” and “sophisticated investors” had no intuitive grasp of the concept. But, what was even more amazing was how many people seemed to to “get it” (which usually took graphical illustrations) but immediately went right back to optimal portfolios with static correlation assumptions.
This is new things to know. Thanks for sharing. I was not aware of this before I read you blog. Thanks…
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