Correlation is Bad News for US Equity Investors

Santorini

Photo: Wikipedia
Santorini – bring Euros.

I submitted a report last fall based on research by Dr. Bruno Solnik, a Professor Emeritus at HEC. My research, much like Dr. Solnik’s, finds strong correlation in international markets, diminishing the benefits of international diversification. To put this in practical terms, your US equities have probably taken a big hit this week as a direct result of the Greek crisis. This may not be a big surprise, since crises around the world tend to have some impact on US markets, but it begs the question: why such a high degree of correlation?

If you read my report, you will notice that correlation between European and US equity markets increased 58% from 1971 through 2011. The MSCI regional indices used include mid-to-large cap companies, providing us a rich sample of stocks to track. Interestingly, there exists a small positive relationship between volatility and correlation. This relationship becomes most pronounced during times of crisis – perhaps the most notable examples are the outbreak of the Yom Kippur War, the Asian Financial Crisis in 1997, and the most recent financial crisis in 2008. In other words, when one market falls others follow to a great extent.

While I don’t necessarily believe we are witnessing the beginning of a financial meltdown – certainly not in the US – the Greek crisis that is unfolding this week has prompted me to reexamine my research. Most of my stockholdings are in the US, and they have taken a bit of a dive as the trouble in Europe unfolds. I’ve sought to use recent data to understand where correlation is and where it is headed.

I used two index funds, the Vanguard FTSE Europe ETF ($VGK) and the Vanguard Total Stock Market ETF ($VTI) to track European and American equity markets (respectively) over the past eleven months. The results aren’t easy to read, but notice that after major dips in the market – and the markets usually fall in synch – correlation shoots up. Because correlation is a trailing measure using the last 20 days of data, the series should be mentally shifted very slightly to the left.

Volatility and Correlation in US and European Equity Markets
Graph

Once more data comes through (this graph only captures the market through last Sunday, the 26th of June), we should start to see a bigger decline in world markets and corresponding spike in correlation.

We would need to conduct a more in-depth study to understand the true impact of the Greek crisis – or any other world event for that matter – on US companies. But it seems likely that troubles abroad are having a hyperbolic effect on American equity markets. For example: El Pollo Loco Holdings ($LOCO), with no restaurants outside of the United States and minimal exposure to overseas headwinds, ended Friday down over 1%. Alibaba Group, a hyped-up stock getting the vast majority of its revenue from China, is down over 2.5%. Despite the tremendous demand worldwide for Chinese goods that certainly drives some of Alibaba’s business, the Greek crisis wouldn’t seem to warrant a $5.5 billion drop in market capitalisation.

While any business is affected by events around the world, I am inclined to believe that situations like the crisis in Greece pump systematic risk into equity markets beyond what is normal or sustainable. Investors should be prepared to see more declines in US stocks over the short term. If the Greek crisis subsides, however, US equity valuations may continue on their frothy rise for some time yet.

A note on methodology: Volatility and correlation are calculated in this article using 10 days of trailing data. My report, on the other hand, covers a longer period of time – that methodology can be found on page 1 of the PDF.

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