Saturday, January 29, 2011

Episodic Correlations, "Knowing", Egos & a "P.S."

Most professional investment managers constantly stress the importance of "diversification", yet very few ponder the real nature of what constitutes "diversification", or if they do, they have either a very "naive" or "lazy" approach. Most rely on "long-term, equilibrium correlation" statistics, but many significant losses can occur in the "short-term", during "disequilibrium" when their less than "parity" correlation assumptions rapidly approach parity and their much relied upon "low correlation" vaporizes right at the moment they need it most.

Correlations are fantastically hard to forecast, but forecasting is not necessarily necessary if you are just willing to be open-minded and accept what the capital markets are trying to tell you. At any given time there are "paradigms" in place that create attractive correlation pairs. Over the past 5 years there have been two major paradigms: 1) Growth can only be found overseas in the emerging markets and 2) THE FEAR TRADE. In a past post, I described why I think #1 is simply silly and potentially dangerous to your brokerage statement ("Growth in the emerging markets is self-defeating, growth in innovation/technology is self-reinforcing."; this principal is rapidly being revealed at present, just pull a 3-year chart of the NASDAQ 100 (QQQQ) vs. the Emerging Market Index (EEM)). The second paradigm, THE FEAR TRADE, is running its course. A great way to see this visually is by the below 2-year chart of the gold ETF (GLD) vs. the financial sector ETF (XLF):

The financial sector ETF has outperformed gold by about 30% over the past 24 months. This is interesting (but apparently not widely known or discussed), but that is not the point of this post. The truly interesting point is that gold and financial stocks had a very significant negative correlation during the crisis, and as a result, they offered an attractive "correlation pairing", but this pairing is transitory or as I like to describe it "episodic". During the middle of the last 2 years, gold and financial stocks demonstrated a much more "positive correlation" (both rising), but now they appear to want to return to a negatively correlated relationship, to the detriment of the price of gold. A few quarters or years from now, this negative correlation will likely be less robust because the "paradigm" of THE FEAR TRADE will have passed. Yet, probably thousands of financial advisors/planners will plug in "long-term, equilibrium correlation" assumptions about gold/financial sector stocks that reflect this history that will indicate a far more effective diversification benefit than will really exist at that time.

Correlations are cyclical and transitory, but that creates an opportunity for those that are a little more proactive and honest about how the world really operates.

Over the next few/several years, I think it is quite possible that financial stocks will double in price, and the price of gold will get cut in half. There are certainly many who would take the "other side" of that trade, but whatever side of the table you are on, it is always prudent to look for what is the antithesis of your "winning trade" and reallocate 20-30% in something that you "know" will lose money, simply because you don't really ever really "know" anything. You can just skew your exposures to reflect the skews in your perception.

There were certainly "gold bugs" who 2 years ago "knew" gold would perform well, and being up over 45% in 24 months would classify as "performing well". Yet, if they had invested 20% in financials, which they also "knew" would largely be "doomed", they would have increased their 2-year return by about 6% cumulatively. On the other hand, had financials fallen another 50% (rather than rising), they would have reduced their return down from 45% to around 25%. 25% is not bad, but do you really think gold would have been up only 45% if financials had fallen another 50% rather than rising around 75%? Probably not.

The point is that if you want to make money, you can be tactical and still remain disciplined and diversified. If you want to be 100% "right"in order to feed your ego, there are far less expensive ways to boost your self-image (i.e. personal trainer, Nutrisytem, sports cars, new clothes, hair replacement, liposuction, etc.) that have more limited downside and greater direct linkage to results.

PS: For those that think I wrote this ignorant of Friday's market action, the riots in Egypt or the threat to the Suez canal, you are wrong. The events in Egypt are not an isolated event and they are likely to be just the current example of a long series of similar events that will occur in the coming years. The age of tyrants is coming to a close. They are going to be Tweeted, blogged and YouTube'd into exile (tyrants can shut the internet down for some period in time, but that just reinforces the mindset that regime change is necessary amongst the young who are most likely to revolt), but the communication age that make this possible will also make the visuals very discomforting. It is a bit like "making sausage", you don't want to watch the process, especially when the flesh that is being torn is human. The regime that will come into power next in Egypt may not be to our liking, but if they (whoever they are) do not respect the rights and desires of the citizens of that country, they are not going to have 30 years this time to enjoy their booty. Technology is accelerating and so is the time frame in which change occurs, and that does not only apply to the feature size of components on the newest motherboard. We all want "change" that leads to a better world, but we need to develop the stomach that is required to make or allow that change to happen. From an investment standpoint:

"Queasy makes making money easy", so get some Rolaids, get "longer" as the videos get uglier and put 20% in something that is a "sure loser", in your mind.

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