High Correlations Ruin Investing: Independent Financial Advice
Posted by Don Martin on Wed, Jan 04, 2012 @ 02:29 PM
2012 Financial Advice: High Stock Correlations Ruin Traditional Investing
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A Wall Street Journal article today quotes BCA Research about rising stock correlations are expected to persist. (Correlation is when stocks move in the same direction at the same time, thus defeating the purpose of diversification).
Their theory is that the benign conditions of the 1990’s and the rise in financial leverage are the source of these conditions.
This is similar to what I have been saying: The market has been propped up by naïve speculators who sell naked Put options, plus the excessive leverage provided by “too big to fail” banks, plus the low or almost no cost Fed Funds borrowing rate. In addition the market is propped up by hedge funds aggressive use of leverage and Put options. However these hyper-leveraged participants need to set hair trigger stop-loss orders which result in a wave of selling at the slightest provocation. This selling pressure is so massive that the result may be that all stocks, both good and bad, come under excessive selling pressure. For example during a crash the need to instantly meet margin calls means that investors sell whatever they can, which means they end up selling the lower risk assets (because the high risk assets are not sellable during a crash) to raise cash to meet margin calls.
The stock market is overpriced and needs to go down to more reasonable levels. When it goes down and stays down then ironically it will be a much safer, less volatile place to invest and correlations will return to normal.
The traditional theory of investing is to diversify to benefit from uncorrelated assets. But that theory is dysfunctional in the modern economy because of rising asset correlations that rise dramatically during a crash precisely at the time when it is important to have assets with low correlation. This is because investors all panic and try to run through the fire escape at the same time resulting in some of them getting trampled.
Until the economy moves into a new era of a bear market capitulation phase the market will have excessive correlations with equity investors taking on extra, uncompensated risk.
I wrote an article “Three things you must know about the crash”.
Investors should seek independent financial advice.
