Net Net: Promoting innovation and managing change
Net Net: Promoting innovation and managing change

Correlation: Two Other Smart Guys Weigh In


Apparently, my report last week about the elevated level of market correlation and the corresponding havoc it was wreaking on portfolios touched a nerve or raised an eyebrow or maybe just twitched a muscle.

The story ran Friday, spanning a convulsion-inducing (at least among ‘Net editors) 1,465 words in describing how closely virtually all the financial market asset classes were running together, and how difficult that makes it to hedge and keep portfolios diversified.

I’m not sure how many readers stayed with me the whole way, but some analysts must have liked it.

Two pretty good ones quickly followed up Monday with analyses of their own about correlation and how much of a problem it poses for investors.

In a piece titled, “Are Elevated Correlations Part of the New Normal?” Standard & Poor’s chief equity strategist Sam Stovall crunched some numbers to take a pretty insider-ish view of all things correlation.

In a nutshell, Stovall determined that, yes, correlation has been high for the past couple of years, but should start shrinking once the market breaks its trading range and the economy starts looking better.

Also, Nick Colas from BNY ConvergEx Group took a stab, offering his “Top 10 Reasons for Increased Asset Price Correlations.” They are:

1) Index-based rather than active investing.

2) Artificially low interest rates

3) Heavy regulation/taxation overhang

4) Globalization of economies and financial markets

5) A fragile housing market

6) Deflation fears

7) High unemployment

8) Memories of recent financial market turmoil

9) High-frequency trading

10) Upcoming elections

So looking at both reports in retrospect, I’d say most of Colas’ reasons were encompassed at least in some way in my story. His very good analysis is more detailed about causes; mine focused more on what investors can do.

As for Stovall’s belief that correlations will return to normal, that’s probably a valid expectation, except I wouldn’t be structuring a portfolio now on what happens when the economy turns around. That could be a long wait.

As a side note…I made mention in the story of a fairly new correlation measure called the Correlation Index (JCJ). It’s a two-year-old tool from the CBOE that measures futures contracts on the SPY, the S&P 500-tracking ETF, against the broad index’s individual components.

The measure is something like the VIX but, I think, is better constructed. The VIX is a silly market measure. It’s supposed to look out at the next 30 days in the market but is barely a reliable gauge for the next 30 minutes.

Ah, but it does have a cool name. And that is the quandary: What should we call the Correlation Index?

My personal leaning is the COX (get it, COrrelation indeX?) OK, nobody else in the newsroom thought it was funny, either.

So what do you think? What should we call the index? HSBC says it’s going to become more popular than the stupid VIX, so it should at least have a neat name.

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