Since the start of the financial crisis, market volatility has declined towards long-term average levels.
Unusually, however, the correlation of share-price performance has remained stubbornly high as the market has remained in a ‘risk on/risk off’ environment driven by macro concerns and reactions to government stimulus measures.
As more investors have sought to place trades based on macroeconomic information, there has been a huge rise in the demand for relatively cheap index-based products such as exchange-traded funds which have amassed $1.4trn globally.
The last time the relationship between correlation and volatility was this unusual was at the peak of the tech bubble.
If volatility remains stable, there is a strong case for falling correlation in the future, because investors will increasingly try to find the best-performing companies in a benign market. Although the uncertainty caused by the disaster in Japan and the unrest in the Middle East has seen a short-term return towards high volatility and high correlations, the main trend in recent months has been a move back to normality.
Dispersion
The outcome of lower correlation in share-price behaviour is greater dispersion and discrimination in returns. At the same level of volatility, as correlation falls, the dispersion or spread of returns increases and vice versa.
History shows us that the normal state of affairs is for returns to display higher dispersion levels than we have seen recently, and this is true for every global sector.
Dispersion is a key ingredient in active, fundamental investing so a return to mean levels of dispersion will benefit those skilled at identifying superior companies.
Portfolio risk
While a fall in correlations would be welcomed by fundamental investors, it would also bring some risks to portfolio construction. Risk-model estimates are currently largely informed by highly correlated, ‘risk on/risk off’ market behaviour, and there are dangers in becoming conditioned by a two-state world.
The standard extreme stress test of a portfolio is to move correlations to 1. Today, an equally valid stress test is to move correlations to 0.2 or less.
Looking at the early part of 2011, there is some evidence of falling correlation and a breakdown of the risk relationships that have become customary. From a situation previously where we could have anticipated most market movements on a binary set of conditions, we have seen a variety of outcomes from different factors.
Risk on/off
For example, in the early part of this year we have witnessed positive returns from securities that would normally benefit from a risk-on environment at the same time as we have seen positive returns for those assets that benefit in a risk-off climate. Emerging markets have underperformed, normally a risk-off sign, although the market was up overall, indicating that investors are willing to accept risk.
To summarise, fundamental investors should have the ability to pick the correct stocks and be able to use them to maximum effect in portfolios. Post-crisis market behaviour has been dominated by highly correlated stock movements that have been problematic for the bottom-up investor.
With correlations so out of kilter with their normal state, we believe that they are primed to break down and that this could herald a period in which markets will make a greater differentiation between individual companies.
While this would be a welcome development for fundamental investors, it could create a more dangerous environment for the use of backward-looking risk models. As a result, investors should make sure they have sufficient breadth in their portfolios.
