Every year investment advisors, analysts and money managers review client portfolios to decide whether to change asset allocations to better reflect risk tolerances and objectives, always with an eye toward improving risk diversification.

But with the market’s expectation of the Federal Reserve tapering its stimulus in the coming months, many of the  relationships among stocks, bonds, commodities and even international markets are already beginning to change.

As 2014 gets underway, we recommend that you maintain a diversified portfolio hedged for inflation and deflation, until the new year’s nascent trends come into better focus. Indeed, diversification is your key weapon against the twin beasts of inflation and deflation.

That’s why a white hot spotlight should be put on the correlation between markets or asset classes this year, because this is one of the essential building blocks to building a diversified portfolio.

Below we highlight how times of market stress can alter a diversified portfolio and make it riskier if nothing is done, and then overview how correlations are changing in five different markets and what investors should do to offset the changes.

A Portfolio Building Block

Correlation is a measure of the tendency of the returns of one asset to move in tandem with those of another asset. In other words, two assets that are “uncorrelated” could be expected to show no systematic, linear relationship between their returns over time. By combining uncorrelated assets, the movements of one asset can be expected to at least partially mitigate the movements of the second asset, reducing the average volatility of a portfolio.

Chart A: Monthly Correlations Between Select Market Segments (1988-2011)


Source: Vanguard

Many assets are imperfectly correlated over time, because the long-run historical correlations may not hold during short-term periods of acute market stress. This dynamic could possibly emerge this year, if the Fed withdraws stimulus too quickly and the private sector is either too slow or not ready to supplant the government’s support.

According to a 2013 paper by Vanguard, “This is because during a flight to quality, increased systematic risk tends to swamp asset-specific risk, and risky assets have a tendency to suddenly become more positively correlated, often in contrast with how they perform during ‘normal’ times.”

This occurred during the global equity bear market (2007-2009), whereas correlations during this period to both U.S. stocks and U.S. bonds increased significantly—virtually across the board. As a result, the long-term diversifying properties at least temporarily largely disappeared, Vanguard found.

This result has prompted some to proclaim the “death of diversification,” though the benefits of diversification, low correlation and sensible portfolio construction tend to bear out over longer periods (3, 5 and 10 years), according to Vanguard’s exhaustive analysis (see Chart A). This is small comfort, though, to investors over the short-term.

Below we take you through five potential changing market correlation trends:

1. International Markets are Becoming More Correlated to U.S. Markets.

Whether its inflation, deflation or stagflation, investors have long counted on international markets to diversify their portfolio away from periods of market stress in the United States to preserve wealth. But a 2008 economics study by Georgetown University business Professor Dennis P. Quinn and his colleagues found that over the last century, capital account liberalizations have been accompanied by higher correlations of national stock markets with those abroad. Also, open countries have maintained higher correlation levels than closed ones (see Chart B).

“Rather, as more and more countries open up to outside capital, the benefits from diversification are likely to decline. The ‘home bias puzzle’ will be commensurately smaller. It is still possible that investors who are among the first to put their money into newly open markets can benefit from uncorrelated returns for a while. Further, high returns appear to follow liberalizations. Yet over the long run, diversification benefits may be small, provided a significant number of investors chase them,” the Georgetown University professor concluded.

As such, we recommend investors take an active inventory of existing international portfolio allocations to review their correlations to the home market and readjust accordingly to preserve the diversification benefits of this asset class.

Chart B: A Century of Global Equity Market Correlations

 
Source: Georgetown University

2. Breakdown in Correlation Between Stocks and Bonds

Bonds have long been expensive, according to BlackRock’s 2014 Investment Outlook, and the problem for stocks: the numerator of the P/E ratio (price) is driving returns, not the denominator (earnings). “Investors have jumped on the momentum train—effectively betting yesterday’s strategy will win again tomorrow,” BlackRock  argues. This situation, the asset manager has observed, means rising correlations between bonds and stocks have made well-diversified, “safe” portfolios riskier than they appear.

But investment bank Société Générale predicts the demise of the relationship that has been observed last year under federal stimulus, where changes in bond yields have been associated with larger changes in equity prices than previous stimulus programs. In other words, when yields rise again (induced by a tapering of QE or the Fed’s stimulus program) as they did earlier this summer, the SocGen fixed income strategists believe the relationship will break down as higher yields fail to boost equity prices.

“We have currently reached a new peak in equities, and the ‘beta’ — that is, the strength of the relationship for equity prices to rise as bond yields rise (the coefficient on ‘x’ in the regression equation) — is probably unsustainably high as the Fed tapers asset purchases over the next six months,” the SocGen strategists wrote, in a note to clients.

Based on their analysis, the projected level of the Dow for a 10-year Treasury yield at 3.00 percent is 15,916; for 3.25 percent it’s 16,338; and for a 10-year Treasury yield at 3.50 percent, the Dow would be at 16,760.

According to SocGen, equity prices won’t collapse this year as the Fed tapers asset purchases, but the level of bond yields will rise and equity prices will be volatile, “moving roughly sideways for a time while both markets re-adjust.”

As noted above, investors are advised to have a diversified portfolio hedged for inflation and deflation until the market’s overall direction becomes clear.

Chart C: Correlation of US Equities and Treasuries (1988-2013)



Source: BlackRock

3. Breakdown in Inverse Correlation Between Equities Versus Commodities

The year 2014 will mark a third year in a row in which commodities have underperformed U.S. equities. Including 2013, the Dow-Jones UBS Commodity Index has fallen for each of the last three years, as the S&P 500 Index scored significant gains over the past two (see Chart D).

Analysts believe that either commodities are too low or equities are too high. If there’s a correction in equities markets, post Fed tapering, many believe commodities markets could come roaring back. This may be investors’ last opportunity to be invested in commodities as a hedge against future inflation at historically low levels.

Chart D: The S&P 500 Has Outpaced Commodities Over the Last Three Years



 
Created with Y Charts

4.  End of Risk-On, Risk-Off Market

Shares are moving less in tandem with the overall market than at any time since the financial crisis, which means investors are focusing on quality names rather than making wide bets on stocks as a whole. For the last few years, the stock and bond markets have been very sensitive to news from the Federal Reserve as well as global financial news. Investors bought almost any stock and bond on good news and sold on bad, a phenomenon known as the “risk on, risk off” market.

As of the end of July 2013, stocks in the Russell 1000 index of large-capitalization stocks had a weighted average correlation of 0.30 to the index itself, the lowest since 2007 and down from 0.57 a year earlier, according to Deutsche Bank data. A reading of 0 indicates stocks are moving with no relationship, while 1 means gains or losses in perfect unison.

These numbers suggest that investors may recognize some stock names are overvalued and are seeking earnings and balance sheet strength. Nonetheless, pricing power should be a key focus for those looking for equity names that can preserve value during inflationary periods.

5.  Dollar, Gold and Oil Relationship to Reverse

Even as we have seen a period of strengthening in the greenback and weakening in gold and oil prices, many analysts believe this relationship will reverse in 2014 (see Chart E).

Analysts at Wells Capital Management expect the dollar to weaken as the global economic recovery takes hold.
“U.S. real GDP growth will likely rise above 3 percent this year and in isolation this would strengthen the U.S. dollar,” Jim Paulsen, chief investment strategist and economist, wrote in a note.

“However, most other economies are also experiencing acceleration in their recoveries. And, in most cases, improvements in foreign growth rates are more dramatic and by comparison to the U.S., should lead to a weaker dollar.”

Paulsen argues that the Fed’s quantitative easing program has not bloated the U.S. money supply and therefore there is no reason to believe that tapering will slow the money supply. “And, if the relative growth of the U.S. money supply does not change much vis-à-vis its trading partners, why should ending QE have much impact on exchange rates?,” he wrote.

Chart E: Dollar, Gold and Oil Trends During the Last 10 Years



Source: Federal Reserve

Portfolio Updates

Investors should get exposed to commodities, now that they are trading at all time lows and diversified commodities indices are not 100 percent correlated to U.S. markets. This move helps create a portfolio that is protected from future inflation. We have various companies and indices in our Thrive and Survive portfolios that can accomplish this.

For example, Goldcorp (NYSE: GG) operates mining assets that include five mines in Canada and the US, three mines in Mexico, and two in Central and South America. The miner also boasts solid pipeline of projects, including the Cerro Negro project in Argentina, the Éléonore gold project in Québec, Canada, the Cochenour project in Ontario, Canada, 70 percent interest in the El Morro project in Chile and 40 percent interest in the Pueblo Viejo project in the Dominican Republic.

Goldcorp’s existing assets, along with several others, will allow for significant production growth for years to come. The company currently pays a dividend yield above 1.9 percent with a historically low dividend payout ratio below 30 percent. Its dividend is sustainable considering the company’s $1.4 billion cash position and the fact that the gold price seems to have finally bottomed as of late June 2013.

Goldcorp is trading down 39 percent over the last year. But we believe that commodities markets will eventually rebound in response to new inflationary pressures when/if Federal Reserve tapering concludes successfully and the economy experiences significant organic growth. Goldcorp is a buy up to 39.

Moreover, iShares S&P Global Materials (NYSE: MXI), iShares S&P Global Timber & Forestry Index (NSDQ: WOOD) and Powershares DB Agriculture (NYSE: DBA) offer commodity plays in broad materials globally, paper and forest products companies, and global corn and grain demand, respectively. Broad materials currently outperform both agriculture and gold (see Chart F).

Chart F: Broad Materials Currently Outperform Agriculture and Gold


Created with Y Charts

MXI is an exchange traded fund (ETF) that offers broad exposure to the vital materials sector-firms associated with metals and mining, chemicals, paper and forest products, containers and packaging, and the construction materials industries. iShares S&P Global Materials is a buy up to 65.

WOOD is an ETF that seeks investment results that correspond generally to the price and yield performance of the S&P Global Timber & Forestry Index. iShares S&P Global Timber & Forestry Index is a buy up to 55.

DBA is a rules-based index composed of futures contracts on some of the most liquid and widely traded agricultural commodities for corn, wheat, soy beans and sugar. The index is intended to reflect the performance of the agricultural sector. Powershares DB Agriculture is a buy up to 30.