How to Diversify When Markets Are Highly Correlated

With economic and political developments driving big gyrations in equity markets, at first blush it seems that all stocks are moving together and diversification benefits have diminished. But as my colleague Andrew Chin explained in a recent article, spreading exposures across the spectrum of equity risk and return factors is now more important than ever. 

 

What kinds of equities should you buy now?

Fundamental analysis goes to the heart of stock selection, but when the market is driven by macroeconomic or political considerations—the situation today—it works less well.

Most stocks continued to rise and fall in tandem in October, whether they were newly discovered traditional bargains or casualties of the European sovereign-debt crisis and US fiscal woes. Stock-pair correlations among global stocks were in the 0.5 range at the end of October, versus a norm of less than 0.2 (Display).

Stock Correlations Are Very High, Factor Correlations Are Very Low

But dig down a layer, and you’ll find that the returns for certain stock characteristics—such as their valuations, price trends, earnings-growth trajectories, analysts’ earnings revisions and profitability—were weakly correlated.

During the early days of the 2008 financial crisis, these so-called return factors, like the stock correlations themselves, tended to march to the same tune. But over the past couple of years, these factors have instead been marching to their own drummers—meaning they have been far less correlated than usual.

This may seem to suggest that there is ample opportunity to outperform by selecting the best-performing factors. But such an endeavor is fraught with risk, because factor leadership can change abruptly—as it did this year.

Investors were so anxious during the first nine months of the year that most of the stock characteristics that over the long term have presaged outsize performance had perverse results: Stocks with bargain prices, superior earnings growth, and even strong price momentum, underperformed. On the other hand, stocks with below-market volatility, rich dividend yields and high profitability were being rewarded far more than usual.

The situation did not totally reverse in the October rally, but return factors behaved more normally, as hopes grew—at least for a time—for political and policy solutions to the European sovereign-debt crisis.

Similarly, some of the worst-performing sectors in the earlier part of the year—almost all of them economically sensitive, such as industrials and materials—were the winners in October. Meanwhile, September’s “safe havens,” such as utilities and consumer staples, lagged.

Perhaps, you might say, the prized and shunned factors (and sectors) simply switched places, and if so, investors should concentrate on stocks with the factors that have traditionally done best.

Not so fast. October may have produced a red-letter rally, but volatility remains disconcerting, with markets rising and falling in response to various US and European political developments. How many investors are confident that the market has found its footing again? Not many, as the market volatility in November shows. Count us in the ranks of the less than confident.

In our view, it is wiser to diversify your holdings to gain exposure to stocks with a wide range of characteristics, including some that are paying off meagerly now. This is a time to embrace diversification—by sector, geography, style and stock characteristics. It’s a time to tread carefully when it comes to taking risk.

When conditions and sentiment improve, stock return factors are likely to behave more normally. But perhaps the biggest lesson of the past few years is that even in more normal times, investors should diversify their overall portfolios broadly across risk and return factors.

This article first appeared on Institutional Investor.com as part of its Global Market Thought Leaders section.

The views expressed herein do not constitute research, investment advice, or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Seth J. Masters is Chief Investment Officer—Asset Allocation and Andrew Y. Chin is Global Head of Quantitative Research and Investment Risk Management, both at  AllianceBernstein.

Seth J. Masters

Seth Masters is Chief Investment Officer of Asset Allocation, Defined Contribution Investments and Bernstein Global Wealth Management and a Partner at AB. He oversees the firm’s asset-allocation portfolios, including Private Client, Target Date, Target Risk, Dynamic Asset Allocation, Inflation Protection and Risk-Management Strategies. In June 2008, Masters was appointed to head AB’s newly formed Defined Contribution business unit. He became CIO of Blend Strategies in 2002 and launched a range of style-blended and asset-allocation services that have since become a significant portion of the firm’s assets. From 1994 to 2002, Masters was CIO of Emerging Markets Value Equities. He joined Bernstein in 1991 as a research analyst covering global financial firms. Over the years, Masters has published numerous articles. Prior to joining Bernstein, he was a senior associate at Booz, Allen & Hamilton from 1986 to 1990 and taught economics in China from 1983 to 1985. He earned a BA from Princeton University and an MPhil in economics from Oxford University. Location: New York

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2 thoughts on “Are Bonds Really Less Risky than Equities?

  1. Hi Patrick,

    Fascinating study. Thank you for sharing it. I was wondering, when you show real returns of stocks broken down by capital gain and dividend yield, are you subtracting the rate of inflation from the capital gain or from the dividend yield or both? In other words, are you showing nominal yield and real capital gain? Or real yield and nominal capital gain? Or some type of adjustment in between. Thanks again for sharing.

    • The methodology applied by the authors of Triumph of the Optimists: 101 Years of Global Investment Returns is to measure real equity total returns and real equity capital gains. I show the dividend yield as the difference between the two. For example, the real equity total return from 1900 to 1910 was 6.8% annualised; the real equity capital gain was 2.0% and we show the difference between the two of 4.8% as the real yield. Incidentally, the returns to the world equity series comprises a seventeen-country, common-currency (US dollar) index and hence real returns are after US inflation.

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