High correlation poised to end, new era to begin

NEW YORK (Reuters) - A high correlation between assets classes has been the hallmark of financial markets this year, with assets moving in seemingly perfect lock-step, but that panorama may be on the verge of breaking down, investors at the 2012 Reuters Investment Outlook summit said this week.

An unusually high level of uncertainty about the global economy spawned by the 2008 financial crisis has driven a “risk on, risk off” investment strategy across financial markets.

U.S. and European fiscal woes have spurred the uncertainty, as has political unrest in North Africa and the Middle East, as well as the earthquake and tsunami that slammed Japan earlier this year. When the uncertainty subsides is unknown.

But security selection and a “bottoms up” view of the investing landscape will return to the marketplace, and investors would be wise to make note, analysts at the summit said.

“We would say that the extremely high, pair-wise correlation that we’ve seen in equities over the last several years is poised to drop,” Art Steinmetz, chief investment officer at OppenheimerFunds in New York, told the summit.

“And therefore stock pickers will start to be able to prove their mettle once again,” Steinmetz said.

The correlation of large-cap U.S. stocks has been about 85 percent in recent months -- measured by the percentage of large-cap stocks that rise or fall in sync with the S&P 500 -- while the correlation among other asset classes also has been high.

The monthly change of eight asset classes in relation to the benchmark Standard & Poor's 500 index .SPX has climbed to trading in sync almost half the time from almost never during most of the 1990s, according to Ned Davis Research.

The eight asset classes include MSCI indexes for international and emerging market stocks, spot gold, copper futures, three-month and 10-year U.S. Treasury debt, the euro and the Reuters-Jefferies CRB commodities index.

For investors, a key insight will be knowing “when that correction finally breaks, and it will break at some point,” said Jane Buchan, chief executive of Pacific Alternative Asset Management Co LLC of Irvine, California.

The high correlation will not break across the board, but a fair amount of dispersion in the price of similar stocks will likely be seen in technology and healthcare stocks, she said.

“One of the interesting exercises to do is to think about in what industries are you likely to see greater dispersion and you’ll probably want to put your long-short equity book in those industries,” Buchan told the summit.

The importance of betting on big themes, such as the rise in gold prices or the fallout from a highly indebted developed world, is likely to ebb as correlations fall, she said.

A lack of dispersion has foiled investors’ returns.

Ultra-low global interest rates, the Federal Reserve’s program of buying government bonds to increase money supply, and active central bank intervention in the Japanese yen and Swiss franc have been behind the historically low dispersion, according to FX Concepts LLC, one of the world’s largest currency hedge funds.

The world’s major commerce currencies have typically traded in a range of about 20 percent, providing wide enough price swings to make money, said John Taylor, chairman and chief executive of FX Concepts.

But this year the range for the currencies of the Group of 10 nations narrowed to 6 percent, the lowest since 2004, from a more typical spread between high and low of about 20 percent.

The narrow band has wreaked havoc on the returns of FX Concepts’s global currency strategy, causing the fund to lose 17.8 percent through October of this year.

Getting a strategy correct isn’t easy. Taylor, who called his returns this year “awful,” said his firm might make five or six mistakes for every three or four things it does right.

“Our job is to ferret the places where you can make a bunch of money, and when there’s no bunches to be made you go crazy trying to find them,” said Taylor.

Reporting by Herbert Lash; Editing by Jennifer Ablan and Leslie Adler