Diversification Has A Short Menu Right Now

By admin_45 in Blog

The topic of the day is asset class correlations – how much various investments have traded in/out of sync with the S&P 500 over 2020 and the last few years. Three points on this:

#1: Since the COVID Crisis hit, non-US equities haven’t provided much of a volatility buffer to an S&P 500 portfolio, but long-dated Treasuries and gold have been better diversifiers.

Here are the trailing 90-day price return correlations and r-squares of various asset classes relative to the S&P 500:

• MSCI EAFE Index: 0.95, r-squared of 90.3%
• MSCI Emerging Markets: 0.91, r-squared of 82.8%
• Russell 2000: 0.94, r-squared of 88.4%

• Gold: 0.20, r-squared of 4.0%
• +20 Year Treasury bonds: -0.51, r-squared of 26.0%

Bottom line: even with yields below 1%, long dated Treasuries have still provided diversification benefits AND good 90-trading day returns (+5.6%); even with no coupon at all gold has as well (+7.9% last 90 days). As much as the S&P 500 (+5.1% over the last 90 trading days) has outshone other equities classes (EAFE flat, EM +4.8%), the price correlations between that index and the others is quite high. This is not unusual. We saw the same thing for years after the 2009 Financial Crisis and 2020 is shaping up much the same way.

#2: Correlations are not static across time, as a look at the last 3 years of price return relationships for these assets classes versus the S&P 500 shows.

First, consider the 90-day correlations between SPY (S&P 500 ETF) and EFA (MSCI EAFE Index of non-US developed economy stocks). While the average correlation over the last 3 years is 0.81, in just that relatively short time they have been as low as 0.57 and as high as 0.96. That’s the difference between an r-squared of 33% (anything below 50% is very good diversification) and 92% (basically no diversification benefit). As mentioned in Point #1, the current r-squared for EAFE stocks is 90%, solidly in the “no benefit” camp.

Moving on to Emerging Market equities (using the EEM ETF), these do have a lower 3-year average correlation to the S&P 500 at 0.73. However, the range across the last 3 years is wide: min of 0.41 (17% r-squared) and max of 0.93 (87% r-squared). The last 90 days’ r-squared of 83% is near the top of the historical band.

Lastly, US Small Cap Stocks (IWM ETF here, Russell 2000 Index) show similar 3-year historical correlation patterns. On average their daily return correlation to the S&P 500 is 0.85 for an r-squared of 72%, but the band goes from 0.68 (r-squared of 46%, good diversification) to 0.97 (94% r-squared, no diversification).

Takeaway: the 2 most striking things about all 3 graphs above are 1) that we sit at 3-year highs for EAFE, EM and US small cap correlations to the S&P 500 and 2) only the most resolute of bull markets (i.e. early and mid-late 2018) can push correlations below 0.7 (r-squared of 50%) and deliver real geographic/market cap diversification.

#3: As far as what all this math means for investing right now, 3 final thoughts:

• Do not add more equity exposure to a portfolio without also considering adding to long term Treasury positions as well. Not even gold has a negative correlation to stocks, just a less positive one. We do believe in gold, as we review regularly, but we also remember how it failed the diversification test in 2008.
• Assume that US small cap, EAFE and Emerging Market equities will remain highly correlated to the S&P 500 for at least the rest of the year. As mentioned, correlations only really break down when investor confidence is high. Even if a COVID vaccine comes by the end of the year, markets know there is still a lot of work to do reassembling the global economy. And there is the US 2020 general election waiting in the wings as well.
• Remember that high correlations can feed outsized market volatility. When there are fewer options to diversify a portfolio, investors adjust equity allocations more quickly when things go south.