05.21.2012
By Terry Flanagan

The Rise And Rise Of Market Correlation

While the correlation between asset classes has been steadily increasing over the past few years, it often spikes amid a host of macroeconomic factors.

“What you had before 2008 were investors looking at single company performance,” said Rob Passarella, vice-president of institutional markets at Dow Jones. “You can throw that out the window now because the markets are now highly correlated.”

When market volatility is high, market correlation usually follows. That volatility is often exacerbated by high-frequency trading firms. While their presence is most felt in the cash equities market, HFT firms have also made their mark in the commodities space.

“With correlations between asset classes tightening—it has become paramount to monitor larger structural flows in credit, currencies and commodities,” said David Lutz, managing director of brokerage firm Stifel Financial. “European credit stress is weighing on banks and contract structure is skewing commodities away from fundamentals.”

“Starting in 2008, the minute Bear Stearns happened and the first wave of the mortgage crisis hit, followed by the bank panic, you had market correlation and it hasn’t really left to a degree,” added Passarella. “You now see linkages between the European and U.S. stock markets moving in tandem together.”

When market volatility is low, assets, particularly single stocks, have lower correlation. This creates an environment where investors can pick stocks based on fundamental factors, rather than macroeconomic factors. During the summer months of 2011, when volatility spiked, all stocks seemingly moved in unison. However, during the trailing months of 2011, volatility declined sharply and some semblance of fundamentals returned.

“Over time, correlation comes and goes,” said Bob Near, head of FX sales of North America for asset manager BNY Mellon. “There are some correlations that have been in place a while.”

These correlations come despite the tendency of investors to change their risk appetites depending on the prevailing market conditions. Since the financial crisis in 2008, there has been a growing trend of investors, particularly institutional, to buy risk (risk on) when inflation is expected and sell risk (risk off) when deflation is expected. The effect of this risk on, risk off type of trading causes asset correlation to become more positive.

The mass movement of large institutions and investors either in or out of asset classes in a big way has caused many assets to become highly correlated. The evidence is clear—since 2008 investments such as stocks, commodities, gold, oil and agricultural commodities have all been correlated.

“Prior to 2008, there was no strong or long-lasting deviation from zero between the commodity and the equity markets,” wrote David Bicchetti and Nicolas Maystre at the United Nations Conference on Trade and Development in a March report on market correlation. “During the second and third quarters of 2008, the correlations departed from zero and moved temporarily to negative territories, and then moved in late September, early October 2008 to positive levels, where they have remained almost constant since then.”

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