August 2017 Update: Falling Correlations by Jack MollerSubmitted by Moller Financial Services on August 6th, 2017
There is an old market adage – “In a bear market, the only thing that goes up is correlation.” In other words, as the emotions of panic and despondency kick in, people start selling everything indiscriminately. Thus, markets start moving in unison. In fact, during the Great Financial Crisis, panic definitely ruled the day with virtually every class of investment being sold except for the safe haven U.S. Treasuries. It was quite challenging to get through that period with an equity-focused portfolio (necessary for long-term growth to make our financial plans a reality) without experiencing a huge, if temporary, portfolio decline. However, things don’t always play out as the adage implies. For example, the Dotcom implosion in 2000 did not end up dragging all markets lower. Smaller companies, international equities, REITs, and bonds all did much better than the tech-heavy, large company indexes – the S&P 500 and the NASDAQ composite. Diversification paid off big then and cushioned the fall. Many of these other asset classes continued their outperformance during the subsequent 2002-2007 bull market.
Correlations At Levels Not Seen in 20 years
Starting from a lower base, correlations rose meteorically during the 2008-2009 period to levels not seen since the Great Depression as outright panic hit the markets. Correlations then stayed elevated for a few years post-recession but have been gradually receding to much lower levels today.
On a recent webcast, Schwab Chief Global Investment Strategist Jeffrey Kleintop pointed to the fact that we are now experiencing some of the lowest correlations in 20 years. When I heard Kleintop point this out, I realized that 20 years almost seems like a lifetime ago to me as back then I was turning 40 (yes, that makes this upcoming birthday another big one) and our company was just six years old. More importantly, for a whole generation of current investors, these 20 years may actually represent an entire investing lifetime for them. They, in fact, may not realize the benefits of diversifying in non-correlated markets. This may in part explain the huge flow of investment dollars into the passive S&P 500 index funds. Why bother diversifying when investments seem to move together and U.S. stocks lead?
Diversification into Non-U.S. Equities Has Paid Off in Past Four Decades
It may be difficult to believe for investors with short memories, but over the past decades investing outside the U.S. has been beneficial. I believe a couple data points make the case:
- Over the past 45 years, the worst 10-year period for U.S. stocks was an annual decline of 4.2%. On the other hand, international stocks as measured by the MSCI EAFE index lost only 1.0% annually. While neither of those decade-long returns were fun, the non-U.S. stocks certainly outperformed during these worst periods.
- During the 40-year period from 1970-2010, an MSCI world index of stocks slightly outperformed an MCSI index of U.S. stocks. Importantly, non-U.S. stocks actually outperformed in three of these four decades – the exception being the tech-led huge U.S. rally in the 1990s.
I am not trying to make the case that international stocks will outperform U.S. stocks going forward, though they are overdue for some better relative performance. Quite simply, I’m pointing out the benefits of spreading out our investments and diversifying. And, like most approaches, the best time to do so is after a period when it hasn’t seemed to work.
Low correlations clearly offer opportunities in a variety of markets outside U.S. large company stocks and U.S. Treasuries. Honestly, as a contrarian, I like the idea that so many investors have moved most of their money into the passive S&P 500 funds while at the same time markets have been decoupling. Some of the money currently invested in these S&P 500 funds will likely end up being repositioned whenever they start underperforming. Most likely repositioning will accelerate when the inevitable decline occurs. As I’ve mentioned in previous commentary, now may be the time when the baton is being passed to non-U.S. Time will tell, but we do know that lower correlations provide many more opportunities as well as the ability to spread risk and lessen the impact of a bear market in any one asset class.