If you subscribe to the bearish view and believe a correction is coming in stocks, you are probably in a bit of a quandary about what to do about it: do you get out of the market completely or get even more aggressive and short some stocks that have big run-ups in price?
I would suggest there is another strategy you can apply to your portfolio that can give you more peace of mind than the nearly impossible task of timing the market: correlation.
Correlation, the concept of two or more things moving together, is a great way to balance your portfolio in a time of uncertainty.
Correlation is important for the simple reason that all investments do not act the same all the time. While some go up, others go down, depending on economic conditions, the industries they are in and other factors.
Of course, everyone loves a bull market when it seems that anything you buy is going up but it’s a lot less fun when bears take over and the same thing is happening on the downside. Bear markets – or when prices are falling broadly – tend to reveal the true correlation of an investment. A good example is what happened to energy-related investments when the price of oil dropped into the high $30 per barrel.
Over the long term, you want to have a portfolio of investments that contain correlated and non-correlated assets. With the right mix, it will mean that not all of your assets or your clients’ assets will move in the same direction at the same time.
The other thing to know about correlation is that it can change. Two investments that may be correlated today or might have been correlated over the past year, can move without warning in opposite directions. Correlations can be difficult to spot and certainly very difficult to forecast.
For fun, let's look at some investments and some correlations and see how well you can figure out what investments correlated and what are not.
On this first graph there is a red line and a black line in the top chart and then there’s a line in a separate chart at the bottom. In this case, the red line is a master limited partnership index, an index of publicly traded stocks of master limited partnerships (MLP) which are typically in the oil and gas business. The black line is a mystery security and you have to guess what you think it might be and the bottom section of the chart simply measures the correlation over the past two years. If it's at the middle line or above on the graph, it's correlated. If it's below, it's not. What you'll notice right away is that this security has shown a fair amount of correlation to the MLP index over the past couple years, although it's been changing and most recently changing significantly
So, let's take this first one and see if you can maybe guess what the MLP index might be correlated to - would it be say the stock market, could it be the bond market or could it be the price of oil?
If you guessed high-yield bonds you guessed right. It makes sense when you think about how master limited partnerships and oil and gas drillers fund themselves.
This next chart is a 10-year chart of the Vanguard-traded REIT index - REIT for real estate investment trusts. Again, the same rules apply here now with this exercise. The mystery security in the black line has been very highly correlated over a decade to the REIT index. What could it be? Real estate would be an obvious and good guess but that’s not it. The mystery security is an EFT that tracks the S&P 500. So, over the past decade, if your clients own this REIT index, they owned the S&P 500, and likely never even knew it.
Let’s look at another one. This time, it is a chart of two non-correlated securities. Again, the red line is identified: it’s the chart for gold, an investment that is most popular during times of economic stress and uncertainty. It has had a pretty good run over the last two years. The black line tracks another security, one that will be very familiar to you. The bottom scale shows that these two investments are currently not correlated. What is the mystery security? The answer: The U.S. dollar, which has been declining rather rapidly in the past six months. Like all currencies, the U.S. dollar is sensitive to a lot of economic factors that can include supply and demand for U.S. goods as well as sentiment about the U.S. economy.
Finding investments that are truly non-correlated can be challenging since our financial markets are so globally interconnected. There is one that you are probably familiar with but never knew that you could invest in: life insurance. An investment in life insurance can provide many great benefits such as the opportunity to earn high yields with low credit (carrier) risk. One of its best features, however, is that it's not correlated to the traditional financial markets (stocks, bond, currencies, commodities and real estate) This means the value of your life insurance investment comes from the actuarial performance within the portfolio of insurance and is not affected by other financial markets such as the price of oil, the high-yield bond spread or the performance of the S&P 500.
Correlation is not necessarily a bad thing. However, a well-informed investor will be aware of its presence and well-constructed portfolio will protected against it.