Diversification: Broken or Forgotten?
By: Jeff Cox | CNBC.com Senior Writer
The HSBC study looked at the MSCI All Country World Indexand found its components to be correlated strongly among US, European and many emerging market nations.
It did find that Japan along with smaller markets like Egypt, Morocco, Pakistan, Sri Lanka and Jordan have lower correlation to other world markets.
Still, investors continue to look to foreign markets for diversification hopes.
"You can't just be in domestic stocks. You certainly have to have an international flavor or exposure in your portfolio," says Paul Simon, CIO at Tactical Allocation Group in Birmingham, Mich. "You truly want to look at asset classes that have the strongest fundamentals, that are in a secular trend. Even in the short term you may have some noise and they may become correlated, but as you move further out on the time scale ultimately fundamentals reassert themselves."
Simon also believes gold, which continues to scale to record highs and has done so regardless of equity market performance, is an effective diversification tool as much as it is a flight to safety and a hedge against inflation.
In the past year, according to the HSBC study, the lowest correlation among industries has been 65 percent (autos and household products) and 69 percent for pharma and retailers, while the unlikely pairing of food and beverage with semiconductors has provided a 79 percent correlation.
Autos and household products have manged to avoid high correlation ratios.
A Matter of Mindset
Ultimately, though, diversification may be hard to achieve simply because of market sentiment. Despite low VIX readings, market volume, sentiment surveys and fund flows show there remains plenty of fear—or at least uncertainty—in the market.
And with any dose of significant news, particularly when it comes to the economy, the few retail investors still in the market join with the dominance of high-frequency traders to pull the market strongly in one direction or the other.
"Investors are like fainting goats. If they get startled, their limbs freeze and they fall over," says S&P's Stovall. "Sneak up behind them and say 'bear market' and they freeze up and move into a more defensive area. If they feel danger is gone they move back into cyclical areas."
The main antidote to excessive correlation, Stovall says, is an economy that returns to normalcy which in turn will lead to a market where defensive sectors can withstand market downturns.
"What it really shows is that despite having a large number of investments in your portfolio, unless you've got Treasurys in there typically you're not diversified," he says. "If you've got large-cap, mid-cap, small-cap, developed markets and even to some extent REITs (real estate investment trusts) and commodities, if the market is going up they're all going up.
"All would benefit from an improvement in economic growth, which translates into an improvement in corporate earnings which translates to a rise in asset prices."
(Editor's Note: This story has been updated since its original publication in September.)
