Correlated risks


Today was a notable down day for most investors. This is a snapshot of the WSJ’s market heat map after today’s close, as monochromatic as I’ve ever seen it. (Update – see TraderMike’s recap of the intraday trading.)

It’s interesting to observe that diversification across asset classes and markets didn’t help you today. All 30 Dow stocks closed down. 99 of 100 Nasdaq-100 stocks closed down. Nearly all of the S&P 500 closed down. Oil, gold, and other commodities closed down. Emerging markets closed down. Basically, equities and commodities got sold, and the proceeds went to cash and bonds. (Update – here’s the summary from today’s Worden Report: “Zero Industry groups advanced while 239 declined. There was one winner in the Nasdaq-100, two in the SP-500 and zero in the Dow. HalfPoint+ Movers were seven against 2174. The Leadership Index was 34 versus 2228.”)

One nominal trigger for today’s selling was a 9% drop on the Shanghai exchange, but there have been any number of reasons to be concerned and raise a little cash for a while.

In general, diversifying an investment portfolio across asset classes and markets reduces overall risk for an equivalent level of returns. This works because the price behavior for different markets is supposed to be relatively uncorrelated over time. Lately, disparate markets have been more correlated than in the past, mostly going up. Today the risk was clearly to the down side, making it likely that your investment portfolio closed lower today, unless you were in cash or bonds. (I’m pleased to have reduced my trading positions in India and China over the past couple of weeks.)

Another unexpected systemic risk exposed today was in the odd behavior of the NYSE around 3pm. The new hybrid (electronic and open outcry) trading system was apparently getting backed up due to heavy order flow this afternoon. The DJIA appeared to gap down by 180 points when the backlog was cleared. Anyone trading intraday off a NYSE data feed probably had some problems. (Update – here’s TraderMike with more detail)

I think the price action today is overdone, but I’m also happy to have exited many of my positions in India, China, and other emerging markets over the past few weeks. This is a good time to think about where to invest after the dust settles, or focus on short term and day trading. (Some of you may be interested in using the Ultra and Ultrashort ETFs.)

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