The Market is Finally Getting Back to “Normal”

by Wall Street Daily
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Submitted by Wall St. Daily as part of our contributors program

Yes, we’re enjoying a powerful bull market right now. But looking back, haven’t the last five years seemed especially stressful?

That’s because they were, at least as far as investing goes.

It all started with the financial crisis, and hasn’t let up since.

Fortunately, the latest data shows that we might be getting back to normal. So you’ll have an easier time making your long-term financial goals become a reality.

Let’s take a look…

Asset Correlation Trend Now Reversing

Normally, stocks, bonds, commodities and other assets move in similar (but different) directions. So by allocating amongst them, you can drastically reduce the volatility of your portfolio without sacrificing return. This is the basis of portfolio theory and asset allocation.

Ever since the financial crisis, these correlations have been elevated.

In the month after Lehman Brothers collapsed, stocks fell 24%, corporate bonds fell 11% and even Treasuries fell 7%.

At first, gold increased. But by the next month, even gold – the ultimate safe haven – dropped 6%.

Since then, this correlation among assets has been maintained. So each time a new stress hits the market, there’s been no safe asset to smooth out your total return.

As the European crisis hit, all assets fell together. Same thing with the Fiscal Cliff fears, uncertainty over the election and Fukushima.

So even though stock volatility has been low – as measured by the VIX – portfolio volatility has not.

We’ve called it the risk-on/risk-off trade. And when all assets move together like this, it makes for stressful saving and investing.

Now though, at least one data point, which comes from the JP Morgan Multi-Asset Correlation Index, is showing that this high correlation is temporary and fading.

The Index measures the relationship between a wide range of assets, including global stocks, currencies and debt. While we haven’t reached normal levels, it appears that the last month has led to a huge dip in correlations.

Here’s a long-term view.

Asset Correlation Finally Waning

We’re currently near 0.40 on the Index. So there’s no doubt that we’ve moved past the worst readings up near 0.70.

Now the question is, what will eventually be determined a “normal” reading? Was it the early 2000s’ numbers around 0.10? Or were the mid-2000s’ – with a reading around 0.20 – more representative of what we should expect?

Wherever we end up, the data backs up our bull argument that risk-on/risk-off is ending, and capital will start flowing into stocks.

At the very least, you should be able to sleep easier while your retirement investments smooth out their peaks and valleys. That peace of mind alone is worth a great deal.

 

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