If you read The Wall Street Journal or the Financial Times, you have likely heard about the “risk trade.” It’s a term journalists have been using with increasing frequency to explain the behavior of financial markets. You see, since the financial crisis struck, risky assets have either been rising together or falling together. There has been much less distinction among the returns of risky assets. You have days where either bonds are up or stocks, commodities, and risky currencies are up—it’s risk on or risk off. This recent phenomenon can be explained by an increase in the correlation among risky assets. The trend is apparent in my chart below, which shows the median correlation of the 10 sectors in the S&P 500 with the index. The median correlation has hovered near a 20-year high for the last couple of years. Historically, the median correlation was much more volatile and considerably lower.
So what? Why should you care about increased correlation in financial markets? If you or your advisor take the style-box approach to portfolio construction, you may have a much riskier portfolio than you believe. When the correlation among risky assets rises, the benefits of diversification fall. Higher correlation is also important for stock-picking strategies. Investors who focus exclusively on bottom-up stock picking are operating blindly in today’s environment. Stocks are reacting much more to changes in the macroeconomic environment than to company-specific fundamentals. Bottom-up stock picking simply isn’t being rewarded today. I’ve long believed that a big picture view is vital to long-term success, but today it is more important than ever.
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