World Markets are Highly Correlated-Still
Global equity markets are very correlated. We confirmed this idea by building our famous Portfolio Diversification X-Ray. The PDX is a matrix of the cross-correlations of returns for a number of traded securities. In this case, we picked 21 securities that represent a wide range of sectors of global equities as well as fixed income and anti-inflation securities. Let’s look at the results and interpret them.
Consider this figure:
The first 14 securities are indexes and ETFs of various segments of the USA equity market. These are followed by a European and a Chinese equity ETF. The last five are currency, fixed income or anti-inflation securities.
Note how the equity indexes are very highly correlated with each other (with most correlations over 0.8 and thus green in the matrix), but very uncorelated with the non-equity securities. GLD, the gold ETF, is truly uncorrelated with both equity and the 30 year T-Bond ^TYX. Interestingly, GLD and TIP (the anti-inflation US treasury security) are moderately correlated at 0.4. We would expect this since they both are used to protect against inflation, but are not equivalent in their structure.
The two rows above the matrix show the returns and volatility of each security. Note that the highest volatility is for VGK (41%/yr) and the lowest is for TIP at 5%/YR. On the other hand, only 7 of 21 securities measured have positive returns for the last 45 days. The highest return was China (FXI at 50%/YR) and the lowest was Dow Jones US Industrials (IYJ at -38%/YR).
We say this matrix, derived from the last 45 days of price action, indicates securities can best be picked based upon estimates of returns, assuming most securities will continue their very high correlations. Only asset classes, broadly categorized as equity/fixed income/anti-inflation, have negative or zero correlations for diversification.
Thus, we see yet again how the asset allocation task requires the asset class be picked before individual securities.