Correlation in Financials, Gold Is 'Disturbing': Strategist
Staff Writer, CNBC.com
Markets are heading back to the "bad old days of 2010", with investors trading off headlines, rather than fundamentals and correlations between asset classes strengthening, according to research by ConvergEx.
The rally in risk assets in the first quarter of the year had driven correlations lower, but recent data suggests that this trend is reversing, Nicholas Colas, chief market strategist of ConvergEx Group said.
"The peak of correlations (between the sectors of the S&P 500) was in the early part of 2010, and it's gone at a slow, grinding pace lower. The problem is that there was a good solid trend in the early part of this year towards lower correlations, and that's what's reversed itself disturbingly in the month of May," Colas told CNBC.com.
This is not necessarily an indicator that markets are taking a turn for the worse, but it does show growing concern over macro factors, Colas said.
"When you look at gold and silver correlations, those should be zero, and that's got a good historical and economic track record of being zero, and those correlations are now both up over 35 this past month. So the fact that precious metals are also correlated with financial assets is also problematic.
"When things move together for a protracted period of time, there's some kind of causal link connected to them. I'm going to say perhaps the month of May for precious metals was more correlation than causation," he said.
While the last time correlations were heading upwards, markets were heading down, this time it is less clear cut, but the high correlations, whatever the direction of the market, are concerning, Colas said.
"While it may feel good to have a whole bunch of assets all going up to new highs every day, it's problematic," he explained. "The lower the correlation between different asset classes, the more money you can put to work in the market."
High correlation across normally uncorrelated assets restricts investors' ability to diversify, Colas said.
"If everything's going up at the same time you cannot put as much money to work in different assets as you can when things are moving a little more independently, and the reason for that is that diversification requires low correlation between asset classes.
"That's the problem with high correlations. It may look great because everything's going up, but that's really not the way investors look at it… when the things that are going up, stop going up, they need something in its place."