“Uncorrelated assets are now correlated,” says Merrill

Here’s an interesting call — and one that will probably be met with sage nods of agreement, given the stressful state of world markets:

“Equity investors should probably look upon bonds and cash as powerful diversifying assets the same as they looked seven years ago upon hedge funds and non-US stocks.”

It is an extract from Merrill Lynch’s latest US strategy update, a full copy of which can be found here.

According to the bank’s analysis, the correlation between various asset classes is changing quickly. Indeed, in the aftermath of the dot comedy bubble, while the search for assets uncorrelated to the S&P 500 took investors into the likes of hedge funds, non-US stocks and commodities, many of the advantages have evaporated.

Back in 2000, hedge funds and the like offered not only significant diversification benefits, but higher returns as well. Persistent low returns generally since then have caused some investors to use additional leverage to boost returns in these asset classes — relying on the theory that the risks associated with the leverage were immaterial when compared to the significant risk-reduction benefits of investing in uncorrelated assets.

Merrill is now saying that the “uncorrelated has become correlated” and that higher returns now simply require taking more risk.

So how do investors now get diversification away from the S&P 500 now? In short, buy bonds (both treasuries and corporate). Oh, and maybe a bit of gold.