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Asset Correlation: Gold, Bonds, Yen Provide Diversification




We've already looked at the high correlation within the stock market that has caused most issues to move together as a herd. By now it should also be clear that this correlation is evident even across asset classes, providing a binary market where risk is either on or off.

Below is a grid covering 31 asset classes, showing through a color gradient, their rolling monthly correlation to each other for the past 12 months (through August 2010). A quick glance to the top left hand side shows how correlated world stock markets have become.

Click for massively large version in a new tab:
asset class correlation grid Oct 2010
Source: Fidelity

It doesn't really matter whether you are holding the S&P 500, small caps, European equities, emerging markets or Asian equities. Everything pretty much moves in lockstep, denigrating any granular decision making within that area. That leaves us with precious few assets that are dancing to their own tune (bluish lines going across the grid). These uncorrelated assets are: gold (including precious metal equities), bonds (government and corporate but not high yield) and the Yen/US cross. These are the only places you can treat as a refuge. Energy, base metals, and hedge funds provide no diversification or safe haven benefits.

This is why I spend a lot of time and energy trying to time the various markets, instead of picking individual stocks. At this point, you could be an amazing stock picker and bottom up analyst but it will do very little good as the tide will lift all issues irrespective of their merit. I don't doubt that short-term trading is still relevant and profitable but I'm referring to fundamental, value oriented - Graham & Dodd (or Warren Buffett) - style investing.

You can use the grid several ways. One way to use it is to fine tune your long-term investment account. Check what you're heavily invested in at the moment and find what asset class you're missing to balance it out. Of course, diversification in and of itself is useless if all you're doing is diluting your performance just to shave off some variability along the way.

Anyway, take a look at it and let me know if any insights pop into your head.

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9 Responses to “Asset Correlation: Gold, Bonds, Yen Provide Diversification”  

  1. 1 hotairmail

    Would an inverse correlation show up as 'uncorrelated' on the grid?

    I'm thinking of yen/usd for instance which surprises me.

  2. 2 Babak

    hotairmail, it would show as a negative number

  3. 3 MJ

    I'm not sure it can be right - did gold really have a negative correlation with equity price over the last year?

  4. 4 Babak

    MJ, the key is to understanding that is that this is a rolling monthly correlation for the past year. Gold is negatively correlated to the S&P 500 index (-0.28)

  5. 5 MJ

    Can you explain exactly what that means - is a rolling 22 day correlation of % daily price changes or something else?

  6. 6 hotairmail

    Thanks for the response Babak - your analysis is as I suspected.

    Right - so using this analysis, a perfect inverse correlation is essentially shown as 'extreme low correlation'.

    I personally consider a lack of correlation to mean 'to have no bearing nor relationship'.

    So to some extent, we still have the 'binary issue' - but a set of options to be in when risk is on and another when risk is off.

  7. 7 Ramon

    HSBC has done a good paper on the Risk On / Risk Off concept here (PDF)

    There is a neat heat map of cross-correlations presented as a movie so you can see how it has varied across time. Worth a look . . .

  8. 8 TJM

    Look at the high correlations of "alternative" strategies to equity indices, as well as other alternative strategies. Looks like high cost beta at 2-and-20.

  9. 9 MachineGhost

    Yeah, after accounting for all the management and performance fees and other expenses, hedge funds do worse than mutual funds which do worse than index funds which do worse than ETF's. ETFs will probably kill off the entire hedge fund industry. Similar to deregulating commissions, ETFs are another great democratization of finance.

    I'm rather surprised gold equities have such a low correlation, almost as good as the bullion itself, but that is likely because gold equities have been underperforming relative to bullion for awhile. Gold equities certainly didn't go up in 2008 to save anyone's bacon as T-Bonds and bulliion did.

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