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Monday, July 26, 2010

A World of Correlation Doesn't Mean Diversification Isn't Important...Or That Stockpickers are Going to Do Better

John Authers, like most of the FT commentators is an intellectual force to be reckoned with something that can't be said for too many commentators in the major US financial publications. Yet in this article on the increased correlation among equities around the world I think he overstates the case a bit.

Investors face a world of correlation
By John Authers
Published: July 23 2010 23:13 | Last updated: July 23 2010 23:37
The world trades in unison. Many bright people spend many long hours pondering which stocks, sectors or countries to buy but, of late, it scarcely seems to matter.
You can see this phenomenon clearly at the national level.... US, Europe and Japan have performed, in dollar terms, since the financial crisis began to break out in February 2007. There have been wide differences in the way their economies have responded over those years but, at any one time, if you know how any one of those regions is performing you have a great steer for how the others will move.
The same is true, with a twist, for emerging markets. Unsurprisingly, they have been more volatile than developed markets. But, with the brief exception of a few months in late 2008, they have also consistently moved in the same direction as the developed world.
Perhaps more startlingly, correlations are even increasing at the level of individual stocks. This week, the Financial Times reported that the correlation between individual US stocks is now higher than it was in the aftermath of the Lehman Brothers debacle, when virtually all stocks were simultaneously marked down. Correlation between the biggest European stocks is also almost perfect.
As for the popular distinction between value investors, who look for companies that are cheap relative to their fundamentals, and growth investors, who try to pick companies when their earnings are in a growth spurt, there are again no distinctions of late. Value and growth indices have constantly moved in the same direction and scarcely diverged.
Of course the above is correct: equity markets move in tandem and increasingly so. But that is not the same as it not making much different which equity classes are held . Here are the one year returns for several equity asset classes
emerging markets 15.7%
eafe (developed) 5.4%
US total mkt   14.3%
US large cap  13.8%(value 14.6% growth 13.1%)
us small cap   19.2% (value 20.7% growth 17.8%)

Looking at the above there is no doubt that investing in any equity asset class would have put you into equities moving in the same direction. But to argue that it doesn't matter where one invests geographically or in terms of market cap or even style is not at all accurate. Hence Auther's conclusion is not fully correct

This has discomfiting implications. Painstaking work crunching through balance sheets appears to be beside the point. Rather, the job now is to spot the direction of the market and buy on that basis, without bothering to pick stocks. Getting the macro picture of the markets right is all that matters.
There has long been evidence (and debate) to argue that the likelihood of consistent success in picking individual stocks is quite low. In point of fact the evidence that the "painstaking work" of crunching numbers ever yielded profits is quite thin,

 Spotting the direction of the macro market would indeed be a valuable skill although again few seem to be able to consistently time the market.

So perhaps its not such a bad thing to abandon hope of stock picking and market timing success, But it might make sense in an equity allocation to stray from a simple cap weighted indexing strategy. Such a strategy overweights large high p/e stocks and underweights the holdings of stocks of developing countries relative to their current and future shares of world GDP. Thus some version of a tilt towards small and value stocks and a tilt towards emerging market stocks relative to their weighting in market cap based indices is justified.

Authers points out reasons for this increased correlation

First, the “good” reasons. Companies are getting bigger and more truly international.
Second, there are good reasons for the macro to dominate the micro. The great chastening of 2008 showed investors that a financial crisis can gobble up all the differences between companies..
His most interesting point(below) regards the feedback loop that exists in financial markets (a factor missing in the academic models of finance) George Soros calls in "reflexivity" and the way new financial instruments are not just part of the financial markets but they actually change them what Richard Booksataber refers to in his great book of the same title as Demons of Our Own Design:

  • Investors lose faith in the ability of managers to pick individual stocks and move to low cost etfs
  • Volume in exchanges tilts towards the etfs rather than the individual stocks
  • The indices start to drive individual stocks rather than vice versa
  • Profitable stock picking becomes even more difficult as macro factors drive the markets.
  • Professional traders and active individual investors move from trading individual stocks to taking macro views through etfs on broad markets or sectors
  • Add in the factor of leveraged trades and derivatives on the indices which exacerbates the volatility and momentum trading.

the tail now wags the dog. Indices of stocks drive the prices of individual stocks

Authers writes:

But high correlations are not just a symptom of the extreme uncertainty that naturally follows an extreme event. The way the markets behave has been driven by the way investors invest.
Passive index funds have grown to take a greater share of investors’ money over the past few decades. In the past decade, these funds have increasingly done business in the form of exchange-traded funds, which can be traded on exchanges on a minute-by-minute basis.
There are good reasons for this, as index funds carry low costs. The problem is that as ETFs account for a greater share of each day’s turnover, so they become more critical in setting the price. If there are big sales of an ETF, it does not sell the stocks that seem most overvalued; it sells stocks in proportion to the index. Hence stocks tend to rise and fall together.
Macro factors should dominate at present but not to this extent. The more investors behave on the assumption that the macro is all that matters, the more it tends to be true – and the greater the risks that stock prices get out of kilter. If the market ever calms down, the indiscriminate way investors now allocate their money should create a killing for those who pick their stocks carefully.

Authers conclusion imo falls into the "hope springs eternal " argument I see no reason to believe that stock pickers are no more likely to consistently beat the indices in the future than they have in the past.