STOCKS have been moving largely in lock step with one another, and with many other assets as well. Especially when prices fall, this can be a source of great frustration.
After all, when markets become more highly correlated, it not only makes diversifying a portfolio seem like a pointless exercise, it also reinforces the feeling that there’s no place to hide.
Yet market strategists say it’s important to understand why stocks and other investments have often been moving in sync, and to appreciate the opportunities that rising correlations create.
Michele Gambera, head of quantitative analysis at UBS Global Asset Management in Chicago, pointed out that the long-term effects of globalization are not the only cause of soaring correlations. “There’s also a short-term, cyclical effect at work,” he said.
As investors have grown more fearful of macroeconomic threats like the European debt crisis and weakness in the global recovery, fundamental factors that typically drive individual security prices have taken a back seat.
Yet this means that even as long-term trends continue to move markets closer together, there will be periods when correlations fall momentarily, giving fundamentally driven investors opportunities to make money.
So far this year, there have been signs of slight divergences in the performance of broad asset classes. For instance, bonds and domestic stocks are up, to varying degrees — the Barclays United States Aggregate Bond index is up nearly 7 percent year to date, the Dow Jones industrial average is up around 5 percent. Meanwhile, the Morgan Stanley Capital International EAFE index of foreign equities is down around 14 percent and the Standard Poor’s GSCI commodities index is largely flat for the year.
And before worries surrounding Italy’s debt crisis bubbled over last week, Doug Ramsey, chief investment officer for the Leuthold Group, said the correlations of 50-day moving averages for stocks in the Standard Poor’s 500 index had fallen slightly from record highs in early October.
Even if these trends turn out to have been short-lived, and Italy’s fiscal problems increase the market’s correlations again, there’s still a silver lining to this market, value-oriented investors say.
“The good news is that whenever the good gets thrown out with the bad in periods of high correlations, mispricing and distortions take place in the market that create wonderful buying opportunities,” said Robert D. Arnott, chairman of the investment management firm Research Affiliates in Newport Beach, Calif.
For example, Mr. Arnott said that as fear over Europe’s debt crisis sent investors fleeing from risky assets in the late summer, investments that had little to do with Europe were hammered.
A potential beneficiary of this, he said, may be investors in non-investment-grade bonds. As a result of the sell-off, the spread in yields between so-called junk bonds and short-term Treasuries has jumped from around five percentage points at the start of the year to nine points.
“A nine-point spread really means that you expect maybe 12 percent of these bonds to go bust every year, and that’s just crazy,” he said. Mr. Arnott noted that the last time spreads widened to this degree, in 2009, high-yield bonds outperformed stocks by almost two to one.
Of course, investors may have to be extremely patient to take advantage of this potential opportunity, as spreads could keep widening for some time before reversing course.
SIMILAR opportunities may be found in equities for long-term-oriented investors.
Edward Chancellor, a member of the asset allocation team for the investment management firm GMO, noted that the firm had exposure to domestic housing-related stocks on the belief that residential real estate might be nearing a trough.
“In the summer, those guys crashed along with everyone else, so we got a chance to buy more of them,” he said. “Likewise, we like Japanese banks and think they’re relatively cheap, but they got cheaper because they went down with European banks.”
In the end, Mr. Chancellor said, valuations are a much stronger indicator of long-term returns than correlations. But in the short run, high correlations can help create some of those values.
Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.
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