Volatility's down, correlations are up and capital's flowing to foreign stocks
By James Picerno
When it comes to analyzing the capital markets, performance
is king. But while returns are often the first number under scrutiny,
veteran wealth managers know that it shouldn’t be the last.
Mindful that there’s more than one way to quantitatively slice
an investment, we ran the major asset classes through numbercrunching
prisms other than performance. The intended quarry:
Noteworthy trends that aren’t already overexposed by the usual
suspects in the financial media. Our hunt turned up several items
deserving further inspection, including the three detailed below:
The global distribution of equity capitalization, volatility trends
and the changing correlations among the broad asset classes.
Let’s start with Mr. Market’s allocation of equity market cap. As
always, the distribution ebbs and flows with economic cycles, the
shifting sands of global competition, etc. Does the division of this
world’s publicly traded capital pie have any bearing on portfolio
design? Yes and no.
Modern portfolio theory suggests that market-cap-based allocations
are optimal, albeit for the average global investor with an
infinite time horizon. Such allocations are therefore suitable for everybody
in the aggregate and nobody in particular. In practice, asset
allocation should reflect an investor’s goals, risk tolerance, time
horizon and so on. But while the distribution of market cap alone
shouldn’t dictate equity allocation for anyone in particular, surveying
its evolving mix offers perspective on what’s passed, what may
be coming, and how investors value the competing equity markets.
Consider that U.S. stocks represented 44 percent of global equity capitalization at the start of 2007, based on S&P/Citigroup Global
Equity Indices (see “Capital Flows,” below). That’s down from
53 percent in 2000. In other words, most of the planet’s equity capitalization
resides beyond America’s shores.
Where has the capital gone? Emerging markets have been a popular
destination. At the beginning of this year, developing nations
claimed 7.5 percent of global equity capitalization—up from 3.8
percent in 2000. Some fared better than others. The Asia-Pacific region
(excluding Japan) continued to hold the lion’s share of capital
among emerging markets.
In the developed world, Europe also has been taking a larger
relative share from the U.S. At this year’s open, European equity
cap claimed 30 percent of the world’s total, up slightly from 2000.
Meanwhile, equity markets around the world have generally
become kinder, gentler mediums of exchange. Falling volatility in
stock markets, in other words, has been a recurring theme.
The waning of volatility has been especially pronounced since
2004, when developed markets joined the downward momentum
already in progress in emerging markets. As illustrated in “Volatility
Stumbles” below, the U.S. stock market and MSCI
EAFE were each about half as volatile at last year’s close as they
were at the end of 2004, based on annualized standard deviations
calculated from 36-month trailing total returns.
The bond market, too, has become calmer with time. The Lehman
Brothers Aggregate Bond Index was about three-quarters as
volatile at last year’s close compared to two years previous.
“There are an awful lot of people out there who are simply ignoring
that we’re in a downswing in volatility,” says Geoff Considine,
president of Quantext Inc., a Boulder, Colo. consulting boutique
that designs investment risk-management software. He warns
against assuming that lower volatility is here to stay. “Volatility
has cycled forever,” Considine notes. “If you make very long-term
plans based on [the recent low volatility], and volatility reverts to
historical levels, people could end up with far riskier positions than
they thought they’d had, especially for retirees or near-retirees.”
Considine says that the longer-term outlook calls for more of
what presently is in short supply—namely, higher volatility. “Longdated
S&P 500 options have much higher volatility than we’ve seen
in the last several years,” he adds.
Considine concludes that the short-memory syndrome seems
to have infected investor sentiment once again. “You should be
assessing portfolios based upon realistic, long-term measures of
volatility, and not just looking at how your portfolio’s done in
the last three years,” he advises. “In very quiescent markets when
volatility is low, people get more and more aggressive because
they haven’t been hit.”
If volatility rises in the future, investors should exploit the trend
by more frequent or perhaps more aggressive rebalancing techniques,
Liz Ann Sonders, chief investment strategist at Charles
Schwab & Co., tells Wealth Manager.
If relatively higher volatility suggests rebalancing opportunities,
some asset classes have been riper than others on that front. In contrast
to stocks and bonds, the Wilshire REIT index’s trailing threeyear
standard deviation was, at 2006’s close, at a peak since 1990,
when our data starts. Meanwhile, the Dow Jones-AIG Commodity
index at the end of last year was within shouting distance of its former
crest in trailing standard deviation posted back in 2001.
Fluctuating volatility and a lengthy stretch of gains inevitably
alter the strategic relationship among the asset classes. The
correlation between the Russell 3000 and Lehman Brothers Aggregate
Bond indices, for instance, has been climbing in recent
years (see “Correlation Evolution,” below). While still low,
the correlation reached a seven-year high in 2006, based on rolling
36-month measures of trailing returns.
Bonds are still a strong diversifying agent relative to stocks,
but less so than in the recent past. In fact, diversification benefits
in general are harder to come by. For a more dramatic example,
consider the correlation between REITs and U.S. stocks.
For about two years through early 2003, REITs and domestic
stocks posted a low correlation in the range of zero to roughly
0.2, pushing above 0.5 in late 2006.
Rising correlations in recent years can also be found between:
n small- and large-cap U.S. stocks
n U.S. bonds and TIPS (inflation-indexed Treasuries)
n U.S. stocks and foreign developed-market bonds
n Domestic high-yield bonds and investment grade bonds
One notable exception is the correlation between U.S. stocks
and commodities. Starting in the second half of 2005, some strategists
warned that the historically low and negative correlation that
commodities shared with traditional financial assets was fading.
But the warning looks premature, based on last year's downturn
in correlation between stocks and commodities (see “Correlation
In a similar vein, the correlation between domestic and foreign
stocks has been trending down for the last two years. Pundits have
been arguing that international equity diversification has become
relatively weaker, based on rising correlation in recent years. Perhaps
that trend is in the process of changing, too.
In fact, correlation, volatility and the distribution of market cap
are never constant. Looking at a one-number reading suggests
otherwise, but the world is more complicated, as the charts above
remind us. Markets, in sum, are dynamic, evolving entities, as are
the associated risks and returns. Portfolio construction, as a result,
should be no less.