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Risk-On, Risk-Off 'Karate Kid' Trade Coming to End: Schwab's Sonders

After dominating investing through 2010, the dreaded market correlation trade is starting to wear off, says Charles Schwab’s Liz Ann Sonders.

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Source: aboutschwab.com

Trading the market this year has been a little like Wall Street’s version of “The Karate Kid.” Instead of Daniel-san being tutored in the ways of “wax-on, wax-off,” traders have been following the “risk-on, risk-off” practice in their own version of money martial arts.

When it’s risk on, that means all asset classes—stocks, commodities, Treasury prices—are all moving higher (except for the US dollar). Risk off means the stock market’s dropping, commodities are falling and Treasurys are losing ground.

“Correlations are starting to come down. It’s a function of where we are in the economic cycle and the market cycle,” Sonders was saying in a phone chat the other day. “That will serve investors well in terms of fundamentals becoming more important. Diversification starts to work a little bit more effectively as you bring more individual investors back into the market and also has the effect of bringing correlations down.”

Sonders may be reaching a bit, but it’s undeniable that correlations have come off somewhat.

The CBOE has switched diversification measures, from the old S&P 500 Correlation Index (JCJ), the contract for which has expired, to the S&P 500 Implied Correlation Index 2012 (KCJ) and the S&P 500 Correlation Index 2010 (ICJ). Both indices indicate correlations well off elevated levels in July and September.

The issue of diversification is a big one for most investors, and it becomes almost impossible if everything is moving in the same direction.

For much of the year we’ve seen asset classes—particularly stocks—on an inverse correlation with the dollar. When the greenback fell, it made dollar-denominated assets cheaper and generally was the rising tide lifting all boats.

But the dollar actually has stiffened in recent weeks and stocks and commodities have managed to rise regardless. At the same time, the oddity of stocks and Treasury prices rising together also has broken down, with yields jumping as equities have risen and returned the market closer to a state of normalcy.

Sonders is pretty solidly bullish on the market—she cautions, though, that gains likely will be “front-loaded” in 2011, with a market surge followed by a possible meandering through the year.

I love that she calls setting a price target for the S&P 500 “such a silly task,” noting that “every strategist is going to change it 10 times during the course of the year.”

Indeed, the market this year is inventing a whole new silly season of price projections. Deutsche Bank with a 1,550 on the S&P with a 16.4 multiple? Please.

Still, she agrees with generally buoyant calls for strong market gains ahead.

“We’re going to get a pretty significant move at some point,” Sonders says. “You have to watch technicals and sentiment as that happens. If that was really excessive and you find enthusiasm and euphoria from individual investors that we’ve seen in past market tops, then I’d be really worried.”

One of the things she sees boosting the economy and the market outlook is what she calls “frugality fatigue,” or the notion that consumers are tired of cutting costs and are ready to start spending.

“Real consumer spending is already in expansion i.e. it hit its 2007 highs already. Real GDP hasn’t done that yet,” she says.

It’s all part of a trend Sonders sees of the economy nearing a “Goldilocks” phase of being just right—which, incidentally, would be a far cry from the current “Karate Kid” market.

“You’d probably get laughed out of the room for saying that’s the environment we’re in. It’s fairly insulting to anyone who’s out of work,” she says. “In the past the term was used to describe an economy growing in a 3 to 5 percent range with low inflation. That’s about the best range for stocks…We used to call that ‘Goldilocks.’”

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