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Proof of health in the market

By Sheyna Steiner ·
Wednesday, January 30, 2013
Posted: 10 am ET

On Monday, Bloomberg reported that global stock correlations have fallen over the past six months. Correlation is a measure of how investments move relative to one another.

Since 2008, all sorts of stocks have moved in lockstep, with companies of all stripes being alternately rewarded or punished with rising or falling stock prices -- completely apart from the inherent value of the stock. But that trend may be on the way out.

From the story "Global stock correlations plunge as Morgan Stanley buys":

A measure of how much the 2,073 companies in the FTSE All-World Developed Index (FTAD01) swing in unison has dropped 31 percent since June, the biggest retreat since at least 1993, according to data compiled by Societe Generale SA and Bloomberg. The indicator ended last month at the lowest level since 2007.

The latest reading of Societe Generale's indicator shows that fears of global risk could be abating, but looser ties among asset classes may not hang around for long, according to Bloomberg.

"Lower correlations won't last because threats to the global economy haven't disappeared, according to Supriya Menon, who helps oversee $400 billion as a strategist at Pictet & Cie. in Geneva," Bloomberg reports.

Boosting the benefits of diversification

In the market downturn that began in 2008, nearly every asset class got smashed. Unless you were heavily invested in cash and very safe Treasuries, it's unlikely your portfolio emerged unscathed.

In the ensuing years of linked returns among asset classes, the obvious conclusion might have been: What's the point of diversification? Highly diversified portfolios were likely less dented in the 2008-2009 market crash than an all-stock portfolio, and they were more likely to experience higher growth in the aftermath than an all-cash portfolio, according to Fidelity Investment's Viewpoints article from last October, "The pros' guide to diversification."

From the story:

While it may have felt like diversification failed during the downturn, it didn't. The major asset classes are not perfectly correlated, only more highly correlated. There's a difference -- it means that diversification still helped contain portfolio losses, only the benefit was lower than before the market decline.

While rising correlations indicate a heightened sensitivity to risk, the opposite is also true: Falling asset correlations indicate that markets may be putting aside the hair trigger, which could be a sign of good times on the horizon for the stock market -- or at least a more "normal" environment.

"When asset classes are tightly correlated, that is indicative of a market top. That's when the market becomes dangerous," says Jeff Sica, president and chief investment officer of Sica Wealth Management in Morristown, N.J.

When everything goes up at the same time, more than likely it will all go down at the same time as well.

"When there is more balanced correlation, stocks will appreciate as bonds decline, and commodities will be completely uncorrelated. That's when you see a healthy market, and it's more indicative of where the market should be," says Sica.

Follow me on Twitter: @SheynaSteiner.

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