Think Local, Act Global?

Derek Hernquist

Correlation patterns are as valuable as anything in my toolkit.  My strategy for every time frame is built on the following chain of events: changing correlation precedes relative price, which precedes absolute price, which precedes fundamentals.

I believe they operate together...relative strength(RS) can't be revealed without some type of split from an asset's recent orbit, but RS means nothing if the price environment works against all assets.  The opportunity AND danger in portfolios revolves around the dynamic backdrop of correlation patterns.

The chart above shows the linkage between U.S. bonds and stocks over the past 10 years.  Forget the prices at the top...the point is, bonds ARE NOT a definitive hedge for equity portfolios.  Over any given quarter, they've offered correlation as low as -.85 but as high as +.69.  Against the backdrop of rising bond prices, this really hasn't been a problem, as the periods of positive correlation have occurred mostly when both classes rose together.  But when building a portfolio, it makes sense to consider the couplings and decouplings that could occur on top of the "local" risk to each stock or asset class.

Bottom line, look at the relationships between each component of your portfolio, and stress test them for a "max correlation" storm.  At least you'll give yourself a look at what could happen in a correlated environment, and allow you to size your positions accordingly.  And remember, only zero correlation indicates true diversification, as negative correlation implies protection that may vanish when you need it most.


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