Dave Nadig: Correlation Conundrums

November 01, 2018

[This article appears in our November 2018 issue of ETF Report.]

 

We’ve been riding this bull market for so long, it feels like it could never end. And that’s a problem.

As I write this, we’re just coming off a pretty rough four days—relatively speaking. Over the seven days ending Oct. 10, the S&P 500 was down almost 5%. That’s not actually a huge deal in the grand scheme of things, but in recent history, it’s big. And that’s been enough to send the financial pundit-sphere into a tizzy about how to play defense when waters get rocky.

The traditional advice is diversification. Make sure you’re in something that’ll “zig” when the market “zags.” The problem is, in modern markets, short-term shocks like this one often drive all asset classes lower as investors of all types decide to sit things out.

I don’t often run charts on the back page, but I think this is an important one. Here we see the S&P 500 (represented by the SPDR S&P 500 ETF Trust, SPY) having, at first, a boring day or so, while the two poster children for diversification: bonds and gold, here represented by the SPDR Gold Trust (GLD) and the iShares Core U.S. Aggregate Bond ETF (AGG), both slipping almost a percent in reaction to the recent increase in rates by the Fed.

 

 

But as the equity market started to roll over, gold had a bad, bad day, and bonds have done exactly nothing. Gold, that great diversifier, was a traitor!

It was only on the Terrible Horrible No-Good Very Bad day of Oct. 10 that we saw gold start to do what gold bugs always hope it will do—go up—while the market went down a lot.

Cold Hard Truth
This reveals the hard truth about today’s markets: Correlations don’t stand still for very long. A year ago, the 30-day correlation between AGG and SPY was -.68. That’s a massive negative correlation that makes diversification enticing.

Going into this seven-day window, that correlation was ever-so-slightly positive. Noncorrelated is still better than positively correlated, but still not a great hedge.

And gold is even more fickle. While it was sitting at -.50 a year ago, in September 2018, gold was positively correlated to the S&P 500 to the tune of .50.

The Point
Diversification is rarely a short-term, sure-fire panacea to protect your portfolio. It takes real time—market cycles—to bear fruit.

With the return of market volatility this fall, there’s an important lesson I know I’m taking to heart: Investing is a long game, and patience is a virtue; don’t let these short-term correlation spikes shake your confidence.

 

Find your next ETF

CLEAR FILTER