We all fall down; Buttonwood

(From The Economist, provided by LexisNexis)
Publication: The Economist

Why investors were not as diversified as they had thought
DON'T put all your eggs in one basket. Investors are taught at stockmarket elementary school that the secret to avoiding financial disaster is to make sure they diversify their portfolios.
But when markets plunged on February 27th shelter was pretty hard to find. First China fell, then European markets, then Wall Street. Emerging markets suffered. Corporate-bond spreads widened (in other words, their prices dropped). Oil declined. Even gold, a supposed "store of value", took a hit. Only the yen and government bonds gained ground.
This marching-in-step has been described by Henry McVey, a Morgan Stanley strategist, as a "market of one". Diversification did not bring the benefits that investors might have expected.
Perhaps it should not be too surprising that, according to Merrill Lynch, over the past five years the Russell 2000 index of small American companies has a 94% correlation with the S&P 500, the main Wall Street index. More alarmingly, international stockmarkets have not offered any diversification either: they have shown a 95% correlation. Yet more startling are the figures showing that hedge funds have recorded a 94% link with shares. Even property has been following Wall Street 81% of the time.
Why should this be? The obvious explanation is the much-touted "excess liquidity" that has been driving up one asset price after another. There is a healthy debate about how to measure this liquidity, or indeed whether the term has any real meaning. But most people agree that the savings surpluses in Asia and the oil exporters have played an important part in fuelling financial markets. JPMorgan estimates that global liquidity increased by $3.9 trillion between 2002 and 2006, of which around 50% came from Asia and 40% from the oil producers.
The bulk of this money went at first into risk-free assets such as Treasury bills and bonds. That drove down the yield on such assets. So other investors were then naturally tempted to look elsewhere for higher returns.
Meanwhile, pension funds have been trying to reduce the bets they have made on shares. This combination has unleashed a "chase for yield" as any asset with an above-average income (or which offered the prospect of above-average returns), has been driven up in price. More speculative investors have been tempted to borrow at the risk-free rate and invest in risky securities, one version of the talked-about "carry trade".
As more money has chased these risky assets, correlations have risen. By the same logic, at moments when investors become risk-averse and want to cut their positions, these asset classes tend to fall together. The effect can be particularly dramatic if the asset classes are small (as in commodities). A few sellers can have a big impact on prices.
This makes it hard to say which asset market is leading the sell-off, whether it is China tripping up Wall Street, or the yen/dollar rate pulling down corporate bonds. Investors are rather like those circus acts who spin plates on top of poles; once one plate starts to fall, the performer must rush to attend to it, risking that others will fall while his back is turned.
The growing importance of hedge funds also makes a difference to correlations. Hedge funds have two important characteristics: they aim to produce absolute returns (in other words, they hate to lose money), and they borrow to enhance returns. That combination makes them quick to cut their bets when prices move against them. In the old days, when pension funds dominated the market, they could (in theory) ride out fluctuations, because of their long-term horizons.
The result, suggests Tim Bond, a strategist at Barclays Capital, is a market with long periods of subdued volatility, as asset prices slowly rise, interspersed with violent corrections, as in May 2006 and the recent sell-off.
How, then, can investors find true diversification from the stockmarket? One answer is to look for assets, such as weather derivatives, that have not yet been discovered by the herd. Another is to use the oldest trick in the book and buy Treasury bonds, the safest of safe havens. Over the past five years Treasury bond prices have tended to move in the opposite direction to shares.
This was not always so. During the 1990s, when inflation and short-term rates were falling around the world, stockmarkets and government bonds tended to move together. That pattern changed after the dotcom bubble burst, as investors fled for safety.
The recent outperformance of Treasury bonds shows that the markets are really worrying about economic growth, rather as they did in 2000-02. Were inflation the scare, investors would be buying commodities. So before investors diversify, they should choose which risks they are trying to avoid.