Ignore Shifting Correlations At Your Peril

September 24, 2014

Yields

This simple model of whether prevailing risk is based on inflation or economic growth solves both the correlation and flight to risk puzzles. In the latter case, when inflation risk prevails, investors may not necessarily jump from stocks to bonds in fear that they are jumping from the frying pan into the fire.

Of course, academic studies are done with the benefit of hindsight. If I were writing this article in 1997 and not 2014, it would be unlikely that anything but inflation proved to be statistically significant in econometric models of stock-bond correlation levels.

However, such models would ignore the fact that price volatility and high inflation levels are likely an indicator—and a manifestation—of latent economic instability. Certainly the incorporation of economic response variables is critical in modeling the stock-bond correlation, but we should by no means assume a perfect model from just these inputs.

Forecasting To 2015

Both Pimco and Deutsche Bank have released papers in the last year: "The Stock-Bond Correlation" and "Long Cycles In The Bond-Equity Correlation: Where Next?" each, respectively, propose econometric models for estimating and forecasting the correlation relationship.

While the implementation of each model is unique, their forecasts are identical: A 0.0 stock-bond correlation in 2015.

If we're moving from a -0.28 average regime to a 0.0-level regime, with fluctuations into both positive and negative territory, investors should consider the implications of this change on the appropriateness of their current asset allocation profile.

To achieve the same expected return profile, increased correlation levels imply that investors will have to stomach higher volatility levels, both in the aggregate and in short-term shocks.

 

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