Weekend Economists Ring in the Old, Wring Out the New: Dec. 30, 2011 to Jan. 2, 2012

[Demeter]

50. When Investors Rush In, and Out, Together

http://www.nytimes.com/2011/12/31/business/economy/when-investors-rush-in-and-out-together.html

It seems that anxious investors in these troubled economic times are seeking safety in crowds. The prices of stocks, bonds and a host of other financial assets, which in normal conditions more often than not move in a diversity of unpredictable directions, are increasingly surging up or down in lockstep. The rise in correlation between individual stocks, but also between completely separate asset classes like stocks and gold or stocks and oil, “has been one of the big themes of the investment climate this year,” said Marc Chandler, a market strategist at Brown Brothers Harriman in New York.

The chief explanation for the correlation is the great uncertainty facing investors — mainly over the crisis in Europe, which has raised the specter of the potential bankruptcy of governments and a collapse of the banking system. With every bit of bad news, nervous investors around the globe have been selling many of their positions across all asset classes, no matter what they are, driving prices down, and rushing into perceived safe havens like cash and United States bonds. But sometimes just a day or so later, with a glimmer of hope that Europe is pulling away from the abyss or that the United States is picking up steam, newly optimistic investors turn around and rush back from cash into harder assets, like stocks, foreign bonds or commodities, pushing prices higher together. “When things are less stressed, stocks and other investments move according to other more fundamental factors like a company’s earnings or its balance sheet,” said Maneesh Deshpande, managing director for global equity derivatives strategy at Barclays Capital. “But when macro fears take over, they move in flocks.”

The downside for investors caught in this maelstrom is that their attempts to spread risk by diversifying their portfolios is less effective. Analysts expect that volatility and correlation will continue to afflict markets in the year to come. In November and December, a common measure of correlation within the Standard & Poor’s benchmark 500-stock index reached as high as 90 percent, the highest since 1996, according to Barclays calculations. For much of the decade leading up to the financial crisis in 2008, the measure of correlation between the 50 biggest stocks in the S.& P. 500 generally stayed between 10 percent and 40 percent.

Financial stocks were the most correlated in the third quarter, but even other sectors — like consumer and health care — that are usually more differentiated experienced “remarkable pickups in correlations,” Candace Browning, head of research at Bank of America, said in a recent presentation...With so much money sloshing around from one day to the next, the high degree of correlation poses a challenge for active fund managers or other stock pickers who pride themselves on their ability to discriminate between stocks or other assets. It may be one reason that some hedge funds are having a tough time. It is also a problem for ordinary investors who have traditionally tried to protect their portfolios by spreading risk over a broad basket of assets, so that if some go down in price, others will increase. But how can you protect yourself in a world where investments rise or fall together?

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