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When Investors Rush In, and Out Together

Graham Bowley |The New York Times
Saturday, 31 Dec 2011 | 1:16 PM ET

It seems that anxious investors in these troubled economic times are seeking safety in crowds.

The prices of stocks, bonds and a host of other financial assets, which in normal conditions more often than not move in a diversity of unpredictable directions, are increasingly surging up or down in lockstep.

NYSE Trader
Photo: Oliver Quillia for CNBC.com
NYSE Trader

The rise in correlation between individual stocks, but also between completely separate asset classes like stocks and gold or stocks and oil, “has been one of the big themes of the investment climate this year,” said Marc Chandler, a market strategist at Brown Brothers Harriman in New York.

The chief explanation for the correlation is the great uncertainty facing investors — mainly over the crisis in Europe, which has raised the specter of the potential bankruptcy of governments and a collapse of the banking system.

With every bit of bad news, nervous investors around the globe have been selling many of their positions across all asset classes, no matter what they are, driving prices down, and rushing into perceived safe havens like cash and United States bonds.

But sometimes just a day or so later, with a glimmer of hope that Europe is pulling away from the abyss or that the United States is picking up steam, newly optimistic investors turn around and rush back from cash into harder assets, like stocks, foreign bonds or commodities, pushing prices higher together.

“When things are less stressed, stocks and other investments move according to other more fundamental factors like a company’s earnings or its balance sheet,” said Maneesh Deshpande, managing director for global equity derivatives strategy at Barclays Capital. “But when macro fears take over, they move in flocks.”

The downside for investors caught in this maelstrom is that their attempts to spread risk by diversifying their portfolios is less effective. Analysts expect that volatility and correlation will continue to afflict markets in the year to come.

In November and December, a common measure of correlation within the Standard & Poor’s benchmark 500-stock index reached as high as 90 percent, the highest since 1996, according to Barclays calculations.

For much of the decade leading up to the financial crisis in 2008, the measure of correlation between the 50 biggest stocks in the S.& P. 500 generally stayed between 10 percent and 40 percent.

Financial stocks were the most correlated in the third quarter, but even other sectors — like consumer and health care — that are usually more differentiated experienced “remarkable pickups in correlations,” Candace Browning, head of research at Bank of America, said in a recent presentation.

“A recession in Europe, the instability in the structure of the E.U. and the euro, uncertainty about the strength of a U.S. recovery and an upcoming presidential election, suggest next year could look very much like this year in terms of finding alpha in a correlated world,” she said.

With so much money sloshing around from one day to the next, the high degree of correlation poses a challenge for active fund managers or other stock pickers who pride themselves on their ability to discriminate between stocks or other assets.

It may be one reason that some hedge funds are having a tough time.

It is also a problem for ordinary investors who have traditionally tried to protect their portfolios by spreading risk over a broad basket of assets, so that if some go down in price, others will increase.

But how can you protect yourself in a world where investments rise or fall together?

Dean Curnutt, chief executive of Macro Risk Advisors, which advises institutional investors on their risk strategies, said that correlation threatened “the old adage of don’t put all your eggs in one basket.”

According to Mr. Chandler, the heightened correlation means “there is nowhere to hide” for investors.

It has happened before.

Correlation went up when markets were volatile during the 2008 financial crisis, and again in May 2010 when the European debt crisis erupted as Greece needed its first bailout and the anxious United States stock market suffered a “flash crash.”

The measures of correlation are closely tied to another closely watched market statistic, the Chicago Board Options Exchange Volatility Index.

The VIX, as it is known, measures the implied volatility of options on the S.& P. 500.

When conditions become volatile, it seems, investors rush in and out of assets together, and that’s when correlation rises.

It’s no surprise that correlation has increased again this year as Europe’s unresolved problems have spread to Italy, sending markets reeling.

The realized correlation within United States equities in the S.& P. 500 is now higher than in 2008, Mr. Curnutt said.

But, he said, it was not just stocks: there has also been an increased correlation between oil and the euro, for example, and other assets like stocks and gold, and between Italian government bonds and Italian bank stocks.

“The commonality they have is they are not cash,” Mr. Curnutt said.

Investors are “jumping out of cash and into something else.” Mr. Curnutt measures the average correlation of daily price moves over a rolling three-month period.

On this basis, the correlation between United States stocks and gold, for example, is now the highest for any three-month period since January 2009, according to Macro Risk Advisors.

The correlation between United States stocks and an index of United States government corporate bonds is the strongest since at least 2000, where the company’s data set begins.

Mr. Curnutt says the effect can be self-reinforcing.

When there is a clear systemic risk, as there is now because of the European debt crisis, investors expect correlation to increase — and so they invest in products like exchange-traded funds, baskets of assets that are intended to perform well in a highly correlated environment.

But these instruments, which have become popular recently, tend to exacerbate the correlation, he said.

“There is a circularity of effect,” Mr. Curnutt said.

The official monetary policy in the United States — keeping interest rates close to zero — is also exaggerating the phenomenon, Mr. Curnutt said, because savers have little incentive to stay in cash and instead rush en masse into other investments when they see glimmers of stability and higher returns elsewhere.

“During this crisis, there has been one big trade out there. Either risk on or risk off,” Mr. Chandler said.

But while correlation has been such a strong feature of the past year, Mr. Chandler detects some signs that it may be gradually diminishing as investors expect the United States economic recovery to become more robust in 2012.

Whereas in the past investors were switching their assets readily between United States stocks and, say, emerging market stocks, an improvement in the United States economy could make the nation’s stocks more attractive.

As a result, investors may now choose to keep more of their money invested in the S.& P. 500.

With less money tumbling around the financial markets from one group of financial assets to another, correlation could fall, he said.

But Mr. Deshpande of Barclays Capital said one interesting aspect of the last month or so was that measures of correlation had remained high even as market volatility has fallen back.

One reason, some analysts say, is that while markets may be anticipating Armageddon in Europe, they are more and more bullish about the recovery in the United States.

As a result, the VIX measure of anticipated volatility in stocks is diminishing. But the lockstep swings of other financial assets remain as investors continue to fret about Europe.

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