“I have often been too bearish about the US equity markets in the last 12 years (although bullish on emerging equity markets), but I think it is fair to say that my language has almost never been this dire. The feeling I have today is that of watching a very slow motion train wreck.”

These are serious words from a serious and respected investment manager, Jeremy Grantham of GMO, describing his sentiments in the light of an overstretched and overleveraged financial system. Although I am by nature not a prophet of doom, my analysis has also been pointing in the direction of the current stock market turbulence assuming more serious proportions than run-of-the-mill corrections like those seen in May/June 2006 and February/March 2007. (See articles on “White knuckles and shaky knees”, “Dow’s 520 point two-day loss” and “How serious is a 312 point market decline?”)

A picture tells a thousand words, and none does it any better than the chart of the Dow Jones World Index (as a proxy for global stock markets), showing a decline of 5.5% since the market’s top on July 16, 2007.

 

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Source: StockCharts.com

Although the short-term technical oscillators are quite oversold (arguing for markets to rally at some stage), the medium-term indicators are firmly in sell mode and starting to hint at a change in the primary trend of stock markets. It is for this reason that I will be analyzing the monthly charts with particular care in order to detect confirmation of a bear phase as opposed to a normal pull-back.

Quite worrying in this regard is the fact that since the advent of the declines all the stock market’s attempts at posting rallies have been particularly feeble in terms of breadth and volume – always a bad sign when trying to gauge the potential of further downside.

I have stated before that this is the type of market where the emphasis should be on the return of capital rather than on the return on capital. But where does that leave one as far as safe-haven investment choices are concerned? Interestingly, the bar chart below shows how the performance of various asset classes has unfolded over the past month. (Please note that the bar representing the US 10-year Treasury Note refers to yield and not price.)

 

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Source: StockCharts.com

Equities in general, and small caps in particular, were major casualties, whereas bond prices (in anticipation of potential bad economic tidings), gold bullion and oil earned the laurels for positive performance. Commodities, in general, also did not perform too badly.

But it would be rather naïve to base one’s medium-term asset allocation decisions on the results of the past three weeks. A more sensible approach is to analyze the correlations of the price movements between a number of stock market indices, bonds, cash, commodities, oil and gold. The following table provides a correlation matrix for these markets based on weekly data from June 1992 to July 2007:

 

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Source: Plexus Asset Management (based on data from I-Net Bridge)

Before interpreting the table, allow me a short note on correlations for those less au fait with statistics. Correlation is a measure of co-movement. If two assets move in lockstep up or down with each other (perfectly co-related) then they have a correlation of +1. However, if one asset has a probability of going up equally to the probability of dropping regardless of the movement of the other asset, then they are not co-related and will have a correlation of 0. Finally, if two assets move in exact opposite directions they are negatively co-related with a correlation of -1.

A number of interesting observations can be made from the matrix, namely:

  • All asset classes have an almost zero correlation with cash, hence the “cash is king” adage used in teeth-gritting times.

  • The Dow Jones Industrial Index has a high correlation of 0.92 with the S&P 500 Index, but a relatively low correlation of 0.30 with the Japanese Nikkei 225 Index, making the Nikkei a good diversifier within the equities asset class but not necessarily escaping any bad news in the US.

  • The markets offering the best safe-haven potential against stock market weakness are bonds (-0.07), oil (-0.04) and gold (-0.02) as these are all negatively correlated with equity indices. Although not quite negative, the Commodities Research Bureau (CRB) Index of a basket of commodities also displayed good diversifying qualities.

It is not surprising that the performance pattern that has manifested itself in financial markets since the start of the declines of stock markets is precisely what one would have expected based on the empirical evidence.

The correlation matrix, however, is by no means exhaustive as more work needs to be done on specific industry groups, as well as on emerging markets – a category with loads of long-term potential, but looking quite vulnerable over the shorter term. (Incidentally, the MSCI Emerging Market Index is down by 6.7% since July 16, i.e. 1.2% more than the MSCI World Index.)

The above is not conclusive research on how to allocate assets in times of declining stock markets, but it certainly provides food for thought in an otherwise confusing (and possibly fearful) environment. And always remember the words of Richard Cushing: “Always plan ahead. It wasn’t raining when Noah built the Ark.”

The stock market fall-out could wreak havoc with equity portfolios, but it is comforting to know that even in these uncertain times some markets offer proper diversification characteristics and, importantly, in some cases even the prospect of positive returns.

It was Warren Buffett who remarked: “It’s only when the tide goes out that you learn who’s been swimming naked”. Isn’t this thoroughly applicable to the current situation where investors are beginning to scurry to find hiding places?

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Source: Unknown

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