Some love for the most unloved bull market in history
by Raul Elizalde - 2014-07-15
A recent Standard & Poor’s report confirms what most analysts suspected: investors were net sellers of equity mutual funds from early 2009 through late 2012, even though the S&P 500 climbed more than 50%. It's possible that they also were net buyers of equity ETFs (Exchange Traded Funds), although not by enough to refute the claim that investors warmed up to stocks only relatively recently. Since the beginning of 2013 they have been net buyers, even though amounts have been modest and participation inconsistent.
Some observers argue that, as always, investors are coming in too late, lulled into a false sense of security by high prices and low volatility. In this mindset, this is a proverbial “calm before the storm” – nothing but a trap.
But a different measure of market dynamics suggests that the rally has not become vulnerable, but actually healthier and more sustainable. That measure is the correlation among assets.
After years of being elevated, correlation has dropped significantly, well below pre-crisis levels. This is an important measure of market health. The correlation between the S&P 500 and risky asset classes like REITs, commodities, Latin American stocks and Asian equities is as low as it has been in years.
Inter-asset correlation, or the degree to which assets move together, is a key measure of diversification. If all assets moved in unison, diversification would not be possible. But because they don’t, assets can be grouped together in a portfolio that has a smoother return than any of its components.
But correlation depends on the general market mood.
It tends to go up when investors are nervous and believe that they must move in and out quickly to take advantage of a few windows of calm that appear in a fear-ridden market. That’s known as a “risk-on, risk-off” environment: investors cease to invest and turn to market timing. Nobody owns anything for very long, everything goes up and down in sync, and diversification benefits evaporate.
Conversely, when investors feel more confident correlations among assets drop. People become more comfortable with longer-term exposures, find that diversification indeed works, and take their time thinking what to buy or sell. Long-term bull markets have generally been accompanied by low inter-asset correlation.
The extent to which correlation has fallen since a year ago is significant, and corresponds to Standard & Poors’ findings that investors started to warm up to equities last year. Because correlation moves slowly, the extent to which it fell suggests that this condition may not be coming at the end of a bull market, but rather at the beginning of a more solid period of market strength.
This does not mean that the stock market is immune to corrections and bouts of volatility. It is definitely possible to lose money in the stock market at any time, regardless of whether correlation is high or low. But long-term investors may have a reason to cheer this development, because low correlation among risk assets is an essential component of market health.
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