introduction
Investing can seem to be a never-ending cycle of booms and busts. The markets and instruments may change – tulips in 1634, tech stocks in 2000, cryptocurrencies in 2021 – but speculators’ drive to make quick money stays constant.
But once investors have weathered one bubble or one other, we are likely to turn out to be more conservative and cautious. The ups and downs, the ups and downs, combined with the trial and error process, help lay the inspiration for our core investment strategy, even when it’s just the normal 60-40 portfolio.
Faced with memories of past losses, battle-hardened investors are skeptical of latest investment trends. But sometimes we should not be.
Every every now and then recent information emerges that upends conventional wisdom and forces us to revise our established investment strategies. For example, most investors assume that higher risk will likely be rewarded with higher returns. However, extensive scientific research on the low volatility factor suggests that the alternative is true. Low risk stocks outperform those at high riskat the least on a risk-adjusted basis.
Likewise, the correlations between long-short aspects – like momentum and the S&P 500 in 2022 – change dramatically depending on whether or not they are included within the calculation monthly or day by day return Data. Does this mean we’d like to re-evaluate all investment research based on day by day returns and test whether the outcomes apply to monthly returns as well?
To answer this query, we analyzed the S&P 500’s correlations with other markets on each a day by day and monthly return basis.
Daily return correlations
First, we calculated three-year rolling correlations between the S&P 500 and three foreign stock and three U.S. bond markets based on day by day returns. Correlations between European, Japanese and emerging market stocks and US high yield bonds have increased steadily since 1989. Why? The globalization technique of the last 30 years has undoubtedly played a job because the world economy has grown and turn out to be more integrated.
In contrast, U.S. Treasury and company bond correlations with the S&P 500 fluctuated over time: they were barely positive between 1989 and 2000, but became negative thereafter. This trend, coupled with positive returns from diminishing returns, has made bonds excellent diversifiers for equity portfolios over the past twenty years.
Three-year rolling correlations to the S&P 500: day by day returns
Monthly return correlations
What happens if correlations are calculated using monthly return data as an alternative of day by day? Your range is expanding. For something.
Japanese stocks performed in another way than their U.S. counterparts within the Nineteen Nineties after the collapse of the Japanese stock and real estate bubbles. Emerging market stocks were less popular with U.S. investors throughout the 2000 tech bubble, while U.S. Treasuries and company bonds performed well when tech stocks declined thereafter. In contrast, US corporate bonds underperformed US Treasuries throughout the global financial crisis (GFC) in 2008, when Treasuries were one in every of the few secure havens.
Overall, the monthly return chart appears to more accurately reflect the history of world financial markets since 1989 than its day by day return counterpart.
Three-Year Rolling Correlations to the S&P 500: Monthly Returns
Daily vs Monthly Returns
According to monthly return data, the S&P 500’s average correlations to the six stock and bond markets have increased from 1989 to 2022.
Today, diversification is the first goal of allocating to international stocks or certain forms of bonds. However, the associated advantages are difficult to attain when the common S&P 500 correlation for each European stocks and Europe is above 0.8 US high yield bonds.
Three-year rolling average correlations to the S&P 500, 1989 to 2022
Finally, by calculating the minimum and maximum correlations over the past 30 years with monthly returns, we discover that each one six foreign stock and bond markets were almost perfectly correlated with the S&P 500 at certain closing dates and subsequently would have provided the same risk exposure.
But could such extreme correlations only have occurred throughout the few major stock market crashes? The answer is not any. US high yield bonds have had a mean correlation of 0.8 to the S&P 500 since 1989. But other than the 2002 to 2004 era, when it was near zero, the correlation was actually closer to 1 for the remainder of the sample period.
Maximum and Minimum Correlations to the S&P 500: Three-Year Monthly Rolling Returns, 1989 to 2022
More thoughts
The aim of monetary research is to achieve real and accurate insights into how financial markets work. However, this evaluation shows that changing something so simple as lookback frequency results in extremely contradictory perspectives. An allocation to US high yield can diversify a US equity portfolio based on day by day return correlations. However, the monthly return data shows a much higher average correlation. So which correlation should we trust, day by day or monthly?
There will not be a right answer to this query. Daily data is noisy, while monthly data incorporates far fewer data points and is subsequently less statistically relevant.
Given the complexity of the financial markets in addition to the asset management industry’s marketing efforts, which regularly promote stock beta under the guise of “uncorrelated returns“Investors should maintain our eternal skepticism.” That means we’re probably best off sticking with the information that the majority recommends caution.
After all, it’s higher to be secure than sorry.
Further insights from Nicolas Rabener and the Finominal Team, enroll for her Research reports.
If you enjoyed this post, remember to subscribe.
Photo credit: ©Getty Images / BanksPhotos
