More Evidence that Correlations Haven't Really Changed

Recently we highlighted an article from Mark Hulbert that detailed why talk of a new era of higher correlations among stocks is misguided. Now, The Wall Street Journal’s Jason Zweig offers more data showing that, when it comes to the correlation of the U.S. market with other markets, perception and reality are very different. 

Zweig say that according to data from global stock index tracker MSCI,  the average monthly correlation of the U.S. with the other countries in the MSCI World Index is 0.80, which seems fairly high. But it’s not high compared to the past — at the end of April, shortly before global markets peaked, it was 0.81, Zweig says; at the end of 2010, it was 0.82; in March 2009, it was 0.87. The average for the past ten years: 0.78. “So, while U.S. stocks are moving very much in tandem with those of other markets,” he says, “they are less linked than they have been in the recent past.”

So why does it feel like markets across the globe have been moving up and down in lockstep lately? Zweig says a recent study may shed some light on that. “Calculating correlations might seem like a task that could be carried out only in the most ‘rational’ areas of the brain,” he explains. “But it turns out that humans process relationships among variables in a region of the brain called the insula, which processes visceral reactions like disgust and pain. The study also suggests that people learn best about correlation by focusing on long-term trends or sequences, rather than on isolated, salient events. Thus, a handful of data points like the market moves of the past few days can distort our impressions of how correlated the world’s financial assets have become.”

(The study, titled “Hedging Your Bets by Learning Reward Correlations in the Human Brain”, can be found here.)

Still, Zweig says that doesn’t mean correlations won’t get higher, with the U.S. and many European countries facing very similar problems — namely debts and deficits. Those issues make inflation and currency weakness risks for investors. One way to protect against those risks, he says, is by investing in U.S. utilities, which tend to have minimal revenue outside the U.S., and whose prices charged “tend to move upward at a fairly steady pace regardless of inflation or interest rates”.