Where to hide from jittery financial markets

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“I have often been too bearish about the US equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

These are serious words from a serious and respected investment manager, Jeremy Grantham of GMO, describing his sentiments in the light of an overstretched and overleveraged financial system. Although I am by nature not a prophet of doom, my analysis has also been pointing in the direction of the current stock market turbulence assuming more serious proportions than run-of-the-mill corrections like those seen in May/June 2006 and February/March 2007. (See articles on “White knuckles and shaky knees”, “Dow’s 520 point two-day loss” and “How serious is a 312 point market decline?”)

A picture tells a thousand words, and none does it any better than the chart of the Dow Jones World Index (as a proxy for global stock markets), showing a decline of 5.5% since the market’s top on July 16, 2007.

 

djw.jpg

Source: StockCharts.com

Although the short-term technical oscillators are quite oversold (arguing for markets to rally at some stage), the medium-term indicators are firmly in sell mode and starting to hint at a change in the primary trend of stock markets. It is for this reason that I will be analyzing the monthly charts with particular care in order to detect confirmation of a bear phase as opposed to a normal pull-back.

Quite worrying in this regard is the fact that since the advent of the declines all the stock market’s attempts at posting rallies have been particularly feeble in terms of breadth and volume – always a bad sign when trying to gauge the potential of further downside.

I have stated before that this is the type of market where the emphasis should be on the return of capital rather than on the return on capital. But where does that leave one as far as safe-haven investment choices are concerned? Interestingly, the bar chart below shows how the performance of various asset classes has unfolded over the past month. (Please note that the bar representing the US 10-year Treasury Note refers to yield and not price.)

 

bar-chart.jpg

Source: StockCharts.com

Equities in general, and small caps in particular, were major casualties, whereas bond prices (in anticipation of potential bad economic tidings), gold bullion and oil earned the laurels for positive performance. Commodities, in general, also did not perform too badly.

But it would be rather naïve to base one’s medium-term asset allocation decisions on the results of the past three weeks. A more sensible approach is to analyze the correlations of the price movements between a number of stock market indices, bonds, cash, commodities, oil and gold. The following table provides a correlation matrix for these markets based on weekly data from June 1992 to July 2007:

 

table.jpg

Source: Plexus Asset Management (based on data from I-Net Bridge)

Before interpreting the table, allow me a short note on correlations for those less au fait with statistics. Correlation is a measure of co-movement. If two assets move in lockstep up or down with each other (perfectly co-related) then they have a correlation of +1. However, if one asset has a probability of going up equally to the probability of dropping regardless of the movement of the other asset, then they are not co-related and will have a correlation of 0. Finally, if two assets move in exact opposite directions they are negatively co-related with a correlation of -1.

A number of interesting observations can be made from the matrix, namely:

  • All asset classes have an almost zero correlation with cash, hence the “cash is king” adage used in teeth-gritting times.

  • The Dow Jones Industrial Index has a high correlation of 0.92 with the S&P 500 Index, but a relatively low correlation of 0.30 with the Japanese Nikkei 225 Index, making the Nikkei a good diversifier within the equities asset class but not necessarily escaping any bad news in the US.

  • The markets offering the best safe-haven potential against stock market weakness are bonds (-0.07), oil (-0.04) and gold (-0.02) as these are all negatively correlated with equity indices. Although not quite negative, the Commodities Research Bureau (CRB) Index of a basket of commodities also displayed good diversifying qualities.

It is not surprising that the performance pattern that has manifested itself in financial markets since the start of the declines of stock markets is precisely what one would have expected based on the empirical evidence.

The correlation matrix, however, is by no means exhaustive as more work needs to be done on specific industry groups, as well as on emerging markets – a category with loads of long-term potential, but looking quite vulnerable over the shorter term. (Incidentally, the MSCI Emerging Market Index is down by 6.7% since July 16, i.e. 1.2% more than the MSCI World Index.)

The above is not conclusive research on how to allocate assets in times of declining stock markets, but it certainly provides food for thought in an otherwise confusing (and possibly fearful) environment. And always remember the words of Richard Cushing: “Always plan ahead. It wasn’t raining when Noah built the Ark.”

The stock market fall-out could wreak havoc with equity portfolios, but it is comforting to know that even in these uncertain times some markets offer proper diversification characteristics and, importantly, in some cases even the prospect of positive returns.

It was Warren Buffett who remarked: “It’s only when the tide goes out that you learn who’s been swimming naked”. Isn’t this thoroughly applicable to the current situation where investors are beginning to scurry to find hiding places?

cartoon.jpg

Source: Unknown

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11 comments to Where to hide from jittery financial markets

  • Gus Eckilson

    On your correlation chart : What does the US 3M TB represent. You have me baffled on that one. l even tried Google. l really appreciate your Postcards. l look forward to them especially with your occasional touch of humor.

  • Gus, it stands for the US 3-month Treasury Bill. I use it as a proxy for cash.

  • mark

    The reader’s question at the end sums it up perfectly.Cash is not even considered an investment destination these days.That will change.

  • Neil Wallace

    A very interesting article,I look foreward to more results from the correlation research. My own best bet by far on an admittedly speculative portfolio has been Silver both as ETF and SSRI/PAAS. Definately a lower correlation than my gold holdings to stocks but potentially more volatile

  • stevo

    “Market Panic!
    by Neesa K. Nockin

    When markets get caught in a panic,
    The lemmings grow troubled and manic!
    Their squealing’s so loud
    That they stampede the crowd,
    And find safety on board the Titanic!”

    The problem with most market prognosticators is that their focus is almost entirely upon short-term considerations. This immersion in trivia causes them to lose sight of the importance of the larger picture and how much of today’s news is merely a reflection and continuation of some broad, secular trend.

    The commentators in the financial media compound this problem by being shills for the bulls at market tops, and as solemn as undertakers at a funeral at market lows. Successful investment requires that one follow his or her own informed star, rather than be guided by the squealing of the lemmings.

    The Dow Industrials being down triple digits in a single session is certainly cause for concern. However, for one who last changed his portfolio to a bullish stance in 2003, my panic level is somewhat different from that of a day trader. My long-range indicators will not encourage me to change my long position in equities until the SPX drops below 1410. At the time I am writing this post, the following stock index prices are all above their 200 day simple moving averages, and the 50 day simple moving averages are all above their 200 day counterparts: NYA; SPX; COMPQ; INDU; TRAN; and UTIL. Therefore, the present, directional characteristic of this market is sideways with high volatility — not yet anything like a bear market!

    Further, if one wishes to venture into stock market voudou, lets make two opposing assumptions: 1) the broad market has bottomed, today’s wash-out will not break the low of several days ago, and the market will proceed irregularly higher from here; and 2) yesterday’s high was the top of an upward swing in a continuing, significant, down wave. If 1) is correct, then the future will take care of itself. However, if 2) proves to be true, then using the type of analysis employed by old-time trader, W. D. Gann, this downward swing would likely end on or around Friday, 31 August, at a likely price of 1376 on the SPX.

    At this point, I am thinking that alternative 1) is our immediate, future course.

  • graham latter

    Thanks for your article. I always thought cash (US3mTb) was more correlated to bonds (JPM US Bond Index)than Equities whereas your chart does not confirm this with JPM US BOND INDEX at -0.27 to cash and Dow / FTSE at 13 and 14 respectively to cash. Is the answer that the JPM US Bond Index is made up of high yield corp bomds (rather than fixed income ) and therefore more akin to equities. Any help you can give in explaining this would be appreciated. Thanks for all you good thought provoking articles.
    Graham Latter

  • Denzil FEINBERG

    (It’s not fair, sending ex-Capetonians the picture of Table Mountain with each email…)

    In Canada, proven portfolio managers have NOT had 35% to 50% in cash as during previous downturns.

    Just one of the hopeful reasons I shall direct some clients’ cash-equivalents to more equities.

    REAL-RETURN BONDS: will RISE with rates. Canada has them, USA has for years. Does SA have RR Bonds?

    Denzil FEINBERG CFP R.F.P. (in Ottawa, Canada)

  • NoFate

    Really good info …thanks!

    I think you missed a possibility though …ETF Shorts. There are shorts (and double shorts) for many of the indices now. I have made good money off a short on the US REIT Index. There are short ETFs now for S&P, NASDAQ, R2k, etc.

    I guess my point is that your alternatives have a correlation near zero …or have little correlation. If you think US stocks are going lower, why not put some of your portfolio in short ETFs? If they aren’t going up, then they must be going down…

    Further, it just seems that if a Beta of 1 will lose you money, then it makes more sense to choose a Beta of -1, not 0.

    Finally, Stevo – There’s a perfect storm a comin’. Housing is going to drag down the consumer, the consumer will drag down employment and then we will be in a nasty recession. Check out the Case-Shiller Housing index …it gives me vertigo dude …scary stuff!

  • Graham, remember that the correlation matrix reflects the correlation between the weekly returns of the different asset classes. Bonds are interest-rate sensitive and can give negative returns (similar to equities) when long-term interest rates rise. Cash and money market instruments (as reflected by the US3mTB) always have a positive return and are therefore more uncorrelated to both bonds and equities.

  • Denzil, we have inflation-linked bonds in South Africa. These are quite popular instruments for the so-called absolute return mutual funds, especially with inflation rising at the moment.

  • [...] Du Plessis, a money manager in Cape Town, does a great breakdown of asset classes that you can use to insulate yourself from jittery [...]

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