Why the common expression “all correlations go to one” may be overstated
Feb 28th, 2008 | Filed under: CAPM / Alpha TheoryIn his book A Demon of Our Own Design Richard Bookstaber describes how the breakdown of basic market physics during Black Monday meant that “all stocks moved together” (see related posting):
“The huge volatility of the market broke down all but the most fundamental relationships between markets and securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analysts’ forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was soldit was like plasma physics: as matter becomes hotter, it becomes less differentiated. The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms. Turn up the heat even more and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.”
Since 1987, the term “correlations go to one in times of stress” has become axiomatic in financial markets. But does research actually back up his common assumption?
In a January research note to clients (Stress Risks within Asset and Surplus Frameworks) available here at AllAboutAlpha.com with free registration), Morgan Stanley’s Marty Leibowitz and Anthony Bova take a good hard look at this phenomenon. According to their report:
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Back in 1987 working in the NZ Treasury I and another colleague did a study of how correlations altered over the before / after the 87 equities crash. NZ was stung very hard with this and did not recover as the US did.
Results were just as reported here. Our correlation with the US tightened. In fact we still have this kind of analyst jargon here that talks of “coupling” and “decoupling” with the US markets. The US futures market used to appear to lock step our every move before we even got out of bed.
So we should not assume, good fund manager excuse as it sounds, all correlations move to “one” necessarily. They didn’t. One should also bear in mind that in trying not to infer cause from correlations that the square root of these things tells you how much a linear equation is explaining… and even with high correlations the answer is… not always that much.
Conclusion - before incurring the vast transaction costs trying to chase changes in correlations think very carefully - and as Liebowitz and Bova suggest, try actually studying them rather than getting the cocktail party version.