Jim Kopas

By now, any investor who has managed a stock portfolio is familiar with diversification and the numerous benefits that accompany a portfolio from exposure across multiple asset classes.  However in today’s complex financial markets simple diversification across asset classes has not provided superior investment returns.  Understanding asset class correlations is crucial to successful investing; unfortunately the majority of investors are unfamiliar with correlation.

What is correlation? 

Yale University’s Chief Investment Officer, David F. Swensen, describes correlation as “the manner in which returns of one asset class tend to vary with returns of other asset classes, quantifying the diversifying power of combining asset classes that respond differently to forces that drive returns.” In general, correlation compares the relative performance of investments in relation to one another.

There are three ways in which investments can be correlated; positively correlated, negatively correlated, or uncorrelated.  Positive correlation occurs when one investment experiences above average returns, the other (positively correlated investment) tends to also have above average returns.  Inversely, negative correlation occurs when one asset experiences above average returns, the other (negatively correlated investment) tends to have below average returns.  If the relationship between the return of two investments can not be determined they are considered uncorrelated.

Why is correlation so crucial? 

A clear understanding of correlation is a vital component to successful diversification and asset allocation. The value added to a portfolio through diversification and asset allocation is primarily due to the reduction in unsystematic risk.  Negative performance results of some investments are offset by the positive performance of others, leading to far less volatile portfolio returns.  An investor will optimize the value of diversification if he/she holds a variety of assets with low or negative correlation among one another.

Let’s take a look at how understanding correlations aid in diversification.  Larry Swedroe uses commodities to illustrate the value of correlation in his article “Why It’s Important to Understand Negative Correlation.” Between 1970 and 2008 the Goldman Sachs Commodity Index GSCI and the S&P 500 displayed an annual correlation of -.07 (low and slightly negative correlation). The graph below shows performance of the S&P 500 and the GSCI during the nine years when the S&P 500 had a negative return.

Commodities (on average 14.9% vs. -15.3% and on median 29.1% vs. -11.9%) experienced above average rates of return during years when stocks experienced negative rates of return. The positive returns that commodities provided helped to offset losses incurred during stock market downturns. Since the long-term correlation between stocks and commodities is slightly negative, commodities provide valuable diversification to stock portfolios. 

In Conclusion, when constructing a well diversified portfolio, managers must gain exposure across multiple asset classes with a broad range of correlations, and if done correctly, it will provide the proper framework to construct a superior portfolio. 

As always, please feel free to leave any feedback in the comments sections below. I look forward to your comments and I will have a new investment article posted early next week.   

Jim Kopas Investments

One of the market strategists that I like to follow is Bob Farrell, the former Chief Stock Market Analyst at Merrill Lynch & Co. Below I have summarized Mr. Farrell’s famous “10 Market Rules to Remember,” courtesy of MarketWatch (June 2008). These words of stock market wisdom are timeless and are important to keep in mind during any stock market environment but are especially valuable to remember today.

1. Markets tend to return to the mean over time

When stocks go too far in one direction, they come back. Euphoria and pessimism can cloud people’s heads. It’s easy to get caught up in the heat of the moment and lose perspective. Recent Example: Housing Market drops after excessive growth.

2. Excesses in one direction will lead to an opposite excess in the other direction

Think of the market baseline as attached to a rubber string. Any action too far in one direction not only brings you back to the baseline, but leads to an overshoot in the opposite direction. Recent Example: Bank lending is now tight after years of lenient bank lending. 

3. There are no new eras — excesses are never permanent

Whatever the latest hot sector is, it eventually overheats, mean reverts, and then overshoots. As the fever builds, a chorus of “this time it’s different” will be heard, even if those exact words are never used. And of course, it — Human Nature — never is different. Recent Example: Look at how far the emerging markets and BRIC nations ran over the past decade, only to get cut in half.

4. Exponential rapidly rising or falling markets usually go further than you think, but they do not correct by going sideways

Regardless of how hot a sector is, don’t expect a plateau to work off the excesses. Markets correct by moving in the opposite direction, dropping sharply after the market becomes overbought and rallying after prolonged market weakness. Recent Example: Take a look at the S&P 500 over the last two years.

5. The public buys the most at the top and the least at the bottom

That’s why contrarian-minded investors can make good money if they follow the sentiment indicators and have good timing. Recent Example: In 1999 and 2000 massive amounts of capital flowed into technology-focused mutual funds (at the stock market peak) and in 2002 and 2003 (at the stock market base) outflows from mutual funds were at their highest level.

6. Fear and greed are stronger than long-term resolve

Investors can be their own worst enemy, particularly when emotions take hold. Gains “make us exuberant; they enhance well-being and promote optimism,” says Santa Clara University finance professor  Meir Statman. His studies of investor behavior show that “Losses bring sadness, disgust, fear, regret. Fear increases the sense of risk and some react by shunning stocks.” Recent Example: Look at your own investment history.  How did your emotions towards the stock market change throughout the “good years” and “bad years?”

7. Markets are strongest when they are broad and weakest when they narrow to a handful of blue-chip names

Hence, why breadth and volume are so important. Think of it as strength in numbers. Broad momentum is hard to stop, Farrell observes. Watch out for when momentum channels into a small number of stocks. Recent Example: Investors could have avoided the Technology bubble had they noticed that large cap technology stocks were artificially inflating the market indexes.  Markets were narrow in 1999, with the S&P 500 (large cap) returning 22.7% while the ValueLine Index (smaller cap) dropped 2.3%.    

8. Bear markets have three stages — sharp down, reflexive rebound and a drawn-out fundamental downtrend

Bear markets rarely bottom out in a simple “V” formation, but instead require some time to base build before the majority of investors become comfortable to rejoin the market. Recent Example: Just look at the S&P 500 Chart over the last Decade; notice the stages of the bear market (1. sharp down, 2. reflexive rebound, and 3. a drawn-out fundamental downtrend).

9. When all the experts and forecasts agree — something else is going to happen

As Stovall, the S&P investment strategist, puts it: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?” Going against the herd as Farrell repeatedly suggests can be very profitable, especially for patient buyers who raise cash from frothy markets and reinvest it when sentiment is darkest. Recent Example: Remember last summer when Oil was at $135 a barrel a vast majority of analysts were predicting oil to continue to rise (some even predicting a $200 price in the near future).

10. Bull markets are more fun than bear markets

Just about everyone can agree with this!

Jim Kopas Investments

 On June 23^rd the 50 Day Moving Average for the S&P 500 crossed above the 200 Day Moving Average for the first time since December 2007.  On Friday, September 4^th, the 50 Day M.A. was 10% above the 200 Day M.A. for the first time since April 20^th 1999.  This is just the 19^th time that the 50 Day M.A. has surpassed the 200 Day M.A. by 10% since 1954, and is another promising sign for a continued market recovery.

Historically, the S&P 500 was higher (on average) 1 month, 3 months, 6 months and 1 year later when the 50 Day M.A. crosses 10% above the 200 Day M.A.  In fact, the S&P 500 was higher one year later in 14 out of the 18 occurrences (roughly 78% of the time), with an average gain of 12.32%.

Courtesy of Dorsey Wright and Associates

I decided to cross reference the results of the Moving Average Performance to one of  Pring Turner Capital Group’s  stock timing models (See Last Weeks Post), to see how the market responded when the 50 Day M.A. crossed 10% above the 200 Day M.A. and the timing model was issuing a buy signal (similar to current market conditions).  The results were impressive, as the S&P 500 was higher one year later in 11 out of the 12 occurrences (more then 91% of the time), with an average gain of 15.69%.

None of the information or opinions expressed within this website shall constitute an offer to sell or solicitation or an offer to buy any securities. Pring Turner Capital Group does not guarantee the suitability, accuracy, or completeness of any content or links provided on this site. No information should be interpreted to imply that past results or performance is an indication of future performance. Use of information is at the readers sole risk and Pring Turner Capital Group will have no responsibility or liability under any subject matter on this website.

Jim Kopas Investments