Hi friends,
Welcome to the first part of my Finance 201 series. In the articles that are labeled under this series, I will assume that you already have a basic understanding of different financial instruments (bonds, stocks, ETFs, hedge funds). If not, do take a look at my Finance 101 series.
As the first part of this "higher level" series, I plan to at a closer look at the different portfolios of famous investors and I will be talking about their respective investment approach and their backtested investment returns. To do that, I felt that it is important for us to understand the performance of different asset classes in different economic climates (like recession, bull, or bear market).
To do that, I will be looking at the correlation coefficient of their returns. For those that don't know what is a correlation coefficient, it is a statistical measure of the strength of the relationship between the relative movements of two variables. Essentially, if I increase by 10%, you increase by 5%, and if I increase by 5%, you increase by 2.5% and if I decrease by 10%, you decrease by 5%, we would be positively correlated. When I change by a certain percentage, you would also change by a certain percentage. A negative correlation would just mean that if I increase, you decrease, if I decrease, you increase. This correlation coefficient is also a measure of a linear relationship.
The values of the correlation coefficient are from -1 to 1. -1/+1 would mean a negative/ positive perfect correlation. While 0 would indicate no correlation.
First off, we will be taking a look at the long-term correlations between the assets (1960 to 2017), then we will take a look at the correlations in different specific economic climates. For the bull market climate, we shall look at 2010 to 2019. For the bear market climate, we shall look at 2007 to 2009 (Great Financial Crisis anyone?). I was hoping to find more data for the other recessions like the dotcom bubble and all that, but I can't seem to find it. Do let me know if you have access to any studies on it.
Long-term correlation (1960-2017):
Across the board, with no distinction between upmarket and downmarket:
Looking at the highlighted portion for Table 3 Part A,
Real Estates (Global Real Estates, Commercial, Residential, etc) has quite a strong positive correlation (0.73) with equities (stocks).
Non-government bonds (think commercial bonds) has a mild positive correlation (0.52) with stocks Government bonds have a weak positive correlation (0.27) with stocks
Commodities (Rare metals like Gold, Silver, Platinum) have no correlation (-0.04) with stocks
Looking at the downmarket (Where the price of the asset ends the year lower than the start of the year) highlighted in red, table 3 part B:
Real Estates have a strong positive correlation (0.76) with stocks
Non-government bonds have a weak positive correlation (-0.36) with stocks
Government bonds have a weak negative correlation (-0.15) with stocks
Commodities have a mild negative correlation (-0.46) with stocks
Hence, we can see that "safe haven" assets like bonds and commodities do exhibit different behavior in a downmarket compared to the average performance. They move into more negative correlations with stocks
Looking at the upmarket (Where the price of the asset ends the year higher than the start of the year) highlighted in blue, table 3 part B:
Real estates have a mild positive correlation (0.58) with stocks
Non-government bonds have a mild positive correlation (0.48) with stocks
Government bonds have a weak positive correlation (0.31) with stocks
Commodities have no correlation (-0.07) with stocks
Hence, we can see that in an upmarket, the assets are more in line with long-term behaviors in table 3 part A. Except for Real estates, which moved towards a more negative correlation with stocks.
Summary for this part (+ means more positive correlation with stocks, - means more negative correlations with stocks and 0 means almost no change):
|Upmarket | Downmarket|
Real estates | - | 0 |
Nongovernment bonds | 0 | - |
Government bonds | 0 | - |
Commodity | 0 | - |
#ADMIRE MY GHETTO TABLE#
These are the long-term performance of these assets.
Here we can see that the 20-years overlapping average correlation between the different asset classes with stocks and bonds.
We will now look at the bull-market correlations from 2010-2019:
We can make the following observations:
Investment-grade bonds have a weak negative correlation (-0.22) with US stocks
Commodities have a mild positive correlation (0.57) with US stocks
Global (All stocks in the world) stocks have a strong positive correlation (0.97) with US stocks
International (All stocks in the world except the US) stocks have a strong positive correlation (0.87) with US stocks
REITs have a mild positive correlation (0.65) with US stocks
Here we can see that this is in contrast with our previous data. This is where I will need to clarify that the 2010 - 2019 is actually an anomaly, as it was the longest bull-market that we have ever seen. So you will need to take note of this observation. Furthermore, an upmarket year in the first part means that a rise of 0.1% would still constitute as an upmarket. While 2010-2019 was upmarket on steroids, with consecutive upmarkets. Hence, I felt a need to look specifically at a bull-market period rather than an upmarket year
Let us take a look at the performance in turbulent times (2007-2009) during the Great Financial Crisis (This is different from the down market, as it represents a significant downmarket. This is in contrast to part one where a 0.1% drop in market price between the start and the end of the year would mean a downmarket)
We can make the following observations:
International stocks have a strong positive correlation with US stocks
Emerging market stocks have a strong positive correlation with US stocks
REITs have a strong positive correlation with US stocks
Commodities have a mild positive correlation with US stocks
High yield bonds have a strong positive correlation with US stocks
International bonds have a mild positive correlation with US stocks
Hence, we can see this dragging effect of stocks for the majority of the financial instruments especially in times of volatility, with all of them having a positive correlation with stocks.
I honestly did not expect this behavior. However, there is a limitation as there are no correlations between stocks and US bonds...
With that, I hope that you can have a good understanding of the different correlations of different assets in different economic conditions. It was certainly beneficial to me. hahaha
With that,
I end today's topic.
Stay vested, Stay frugal my friends,
Dionysius
Sources:
https://www.guggenheiminvestments.com/mutual-funds/resources/interactive-tools/asset-class-correlation-map
https://www.vanguard.co.uk/documents/adv/literature/dynamic-correlations.pdf
https://academic.oup.com/raps/advance-article/doi/10.1093/rapstu/raz010/5640504
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