One of the major themes since 2008 has been the immense increase in cor­re­la­tions among asset classes. While this was already a grow­ing trend since mid decade with the pro­lif­er­a­tion of com­put­er­ized trad­ing tech­niques and the rise of the ETF (i.e. when an ETF is bought en masse, all under­ly­ing equi­ties are bought regard­less of indi­vid­ual mer­its…. and vice versa) – it has accel­er­ated in the 2008–2011 period. Head­line risk and macro move­ments have come to dom­i­nate caus­ing neck break­ing whiplash. We call this “risk on”, “risk off” – although I’ve called it ‘stu­dent body left (right) trad­ing’ before the for­mer terms became pop­u­lar. While there have been times these cor­re­la­tions less­ened dur­ing 2010 and early 2011, the back half of 2011 brought the return of this action in force. To wit, James Grant has noted that in the entire his­tory of the S&P 500 there have been 11 instances where 490+ of the 500 stocks traded in the same direc­tion. Of those 11, 6 have hap­pened since July 2011. An incred­i­ble sta­tis­tic. Essen­tially each day you “buy risk” (risk on) or you “buy US Trea­suries” (risk off) – and every 24 hour period is unto itself, with no mem­ory of the pre­vi­ous day.

This type of move­ment has cre­ated havoc for any­one try­ing to out­per­form the index, because often the mar­ket moves down (en masse) than 48 hours later a rumor or a ‘res­cue’ will move all the same assets up en masse. And this gyra­tion con­tin­ues day after day, week after week, mak­ing it impos­si­ble to ride this buck­ing bronco. To that end, both mutual funds [Dec 20, 2011: Aver­age Mutual Fund Down 5.9% with a Hand­ful of Days Left in the Year] and hedge funds [Dec 20, 2011: Every Major Hedge Fund Strat­egy Also a Loser in 2011] have had a hor­rid year try­ing to beat the indexes. Last evening, I went through the Morn­ingstar top fund per­form­ers of the year to see what I could glean. Not much. It was a whose who of util­ity (yield) mutual funds – trailed by div­i­dend pay­ing (yield) large cap health­care and REIT (again a reach for yield) funds. These are now the most crowded trades on earth, now that gold has been blud­geoned of late. As these ‘safe’ sec­tors become ever more crowded, they are becom­ing less safe by the week – we all know how these crowded trades end. It is just a mat­ter of when.

As I ana­lyze the back half of the year, there has been no place for trend trad­ing or cre­at­ing multi month strate­gies – it has been “get in, scalp, and get the hell out” – prefer­ably in 72 hours or less. Rinse, wash, repeat. Only a mar­ket the day­trader or very short term scalper can thrive in and even he/she has had trou­ble because so many of the move­ments occur overnight due to Europe, so U.S. mar­kets usu­ally gap up or down at the open and within 20 min­utes go side­ways the rest of the session.

But back to the lem­ming like behav­ior of risk on, risk off – the NYT takes a closer look:

(note: for some rea­son, I can­not embed a nice graphic from the NYT story – so go here to take a look)

• 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.”
• 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.
• 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?
• The real­ized cor­re­la­tion within United States equi­ties in the S.& P. 500 is now higher than in 2008, Mr. Cur­nutt said. But, he said, it was not just stocks: there has also been an increased cor­re­la­tion between oil and the euro, for exam­ple, and other assets like stocks and gold, and between Ital­ian gov­ern­ment bonds and Ital­ian bank stocks. “The com­mon­al­ity they have is they are not cash,” Mr. Cur­nutt said. Investors are “jump­ing out of cash and into some­thing else.”
• The offi­cial mon­e­tary pol­icy in the United States — keep­ing inter­est rates close to zero — is also exag­ger­at­ing the phe­nom­e­non, Mr. Cur­nutt said, because savers have lit­tle incen­tive to stay in cash and instead rush en masse into other invest­ments when they see glim­mers of sta­bil­ity and higher returns else­where. “Dur­ing this cri­sis, there has been one big trade out there. Either risk on or risk off,” Mr. Chan­dler said.

Dis­clo­sure Notice

Any secu­ri­ties men­tioned on this page are not held by the author in his per­sonal port­fo­lio. Secu­ri­ties men­tioned may or may not be held by the author in the mutual fund he man­ages, the Pal­adin Long Short Fund (PALFX). For a list of the afore­men­tioned fund's hold­ings at the end of the prior quar­ter, visit the Pal­adin Funds web­site at http://www.paladinfunds.com/holdings/blog

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