What Correlation Tells Us...
Among the things we like to watch to assess global markets conditions, are indicators of speculative positioning, investor confidence and cross asset correlation.
To assess speculative positioning, we track the weekly CBOT report and ETF fund flows;
For investor confidence, we track our “Confidometer”;
As regards cross asset correlation, we monitor the 10d, 1month, 1 year and 5 years correlation of a serie of asset class representative vs. that of the S&P500.
Why does correlation matter and why choosing the S&P500 as anchor?
Just like the earth turns around the sun, most financial assets turn around the S&P500 not least because the S&P500 serves as a performance boggy for most asset managers. Most of them will trade the s&p500 to increase or decrease beta (market risk) exposure.
Another reason is that the s&p500 conditions bull/bear perceptions in equities, risk appetite, wealth effects and to a large extent the health of the (world) economy.
Last but not least, cross asset correlation (and volatility) determines diversification benefits which is a key parameter in any risk model, starting with ‘value at risk’ which is used extensively in the asset management industry to construct portfolios. In one word or two, the higher the correlation the higher the “var”. In a low yield and low volatility environment, diversified portfolios are constructed and often leveraged such as in ‘risk parity’ portfolios. Whenever positive correlation increases across asset classes, value-at-risk numbers increase, all other things remaining equal. And whenever var models shout, risk and portfolio managers listen and they respond by reducing leverage and liquidating assets. Hence the interest to track correlation patterns (the same way as volatility which is the second most important variable in value at risk models) so as to anticipate the impact on value at risk risk and how portfolio managers are likely to respond.
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