Beyond that, no modeling of asset correlations would be brought into the modeling because
risky asset correlations go to one in a crisis.
If the markets come up with another one, like
risky asset correlations, it will have validity, restraining speculative behavior, until people overwhelm it, and a new bust happens.
Not exact matches
To be sure, global policy liquidity has played the lead role in pushing
asset prices to new highs, with strong
correlations across both risk - free and
risky assets.
The lack of liquidity and higher leveraging of investments via crowdfunding platforms relative to REITs makes them much
riskier, yet their incrementally higher promised returns and incrementally lower implied
correlations with other
asset classes don't seem to compensate for the added downsides.
Correlation relates to the fact that a low volatility environment encourages investors to move into
riskier assets to get decent returns on their investments.
Fortunately, high
correlations with oil since earlier this year have meant strong performance for most of these
riskier assets.
Stretched valuations, high levels of uncertainty about the macroeconomic backdrop and tight
correlations would seem to warrant a closer look at
assets that can help offer true diversification benefits and downside protection in the event of another synchronized decline across a whole spectrum of
riskier assets.
Fortunately, high
correlations with oil since earlier this year have meant strong performance for most of these
riskier assets.
Do
asset correlations rise near peaks for
risky assets?
However, the high
correlation between
risky assets experienced recently like during the recession of 2001 - 2003 and the global financial crisis in 2007 - 2009 has caused many investors to reconsider allocating by traditional
asset classes defined by security type like stocks, bonds and real estate or commodities.
To be sure, global policy liquidity has played the lead role in pushing
asset prices to new highs, with strong
correlations across both risk - free and
risky assets.
Do I disagree that
correlations begin rising among
risky assets toward the end of a bull market?
We can see this dynamic at play in the figure below, which looks at the
correlation between the amount of money flowing into
risky assets (emerging markets, high yield debt) and the balance sheets of the four largest central banks.
The one thing to worry about is the combination of higher than average VIX backwardation with high
risky -
asset (stock / commodity)
correlation.
Markowitz showed that by combining
risky assets that have less than perfect
correlation, you can create a portfolio that has lower risk and a higher expected return than its individual components.
The fears got worse when the Fed raised rates as evidenced by the spiking
correlation between the
risky assets, stocks and commodities.
The highest
correlations (
riskiest two -
asset portfolio combinations) are colored the darkest red; the lowest (negative)
correlations (least
risky two -
asset portfolio combinations) are colored the darkest green.
These don't move in perfect lockstep, so natively the return drivers of the
risky components of the
assets are 60 - 90 % correlated over the long run (the
asset side of
correlation, think of how the cost of capital moves in a correlated way across companies).
Losing money in your portfolio at the same time you lose your job is even worse, and that
correlation is what makes «risk
assets»
risky.
Correlation relates to the fact that a low volatility environment encourages investors to move into
riskier assets to get decent returns on their investments.
For now, if a
correlation with stocks does exist, some analysts have suggested that cryptocurrencies such as bitcoin could be an indicator of appetite for
risky assets such as equities.