The stock market today reminds me of the hit 1960s song "Nowhere to Run," by Martha and the Vandellas. When the market tanks nowadays, just about all stocks go down in unison. And that high degree of correlation isn't limited to U.S. stocks. Stock markets around the world now seem joined at the hip -- a bad day in Asia rolls over into losses in Europe and further declines in the U.S.
This phenomenon cuts across all asset classes. When stocks plunge, the prices of commodities -- particularly oil, and even gold -- are likely to head lower. Corporate bonds, except the very few with the highest ratings, also suffer. If it weren't for Treasury bonds and the Japanese yen, two asset classes that have reliably bucked a falling stock market lately, there truly would be "nowhere to run, nowhere to hide."
There are two primary causes of the increased correlation among assets. The first is globalization. Sophisticated investors today buy and sell in all the world's markets and react to instantaneous communications that everyone receives at more or less the same time. Second, since the 2008 financial crisis, we have been experiencing broad economic shocks that overwhelm company- and industry-specific developments.
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Risk On, Risk Off
Traders have a description for the sort of market activity that we've seen in the past year: "risk on" and "risk off" days. On risk-on days, traders feel optimistic about economic prospects and buy risky assets, such as stocks and commodities, and shun Treasury bonds and Japanese yen. The opposite happens on risk-off days. Traders sell stocks and commodities and buy Treasuries and yen. (Many international traders borrow yen at Japan's low interest rates to finance their purchases. On days when they decide to rein in risk, they buy yen to repay their loans, driving up the currency's price.)
Given the increased correlation of stocks and commodities, investors may well ask whether it would be smart to hold some Treasury bonds or Japanese yen (or both) to offset the volatility of the stock market. The answer is yes if you check your portfolio frequently and get upset when stocks fall sharply. But if you do buy Treasuries or yen, be aware that current yields on these assets are extremely low and that you run a real risk of losing money if interest rates rise (bond prices move in the opposite direction of yields).
The same goes for investors who seek to hedge against falling stock prices by buying exchange-traded funds that are designed to gain value when the market sinks. In the short run, inverse ETFs could insulate your portfolio against shocks. But because of the way these ETFs are constructed, their prices will fall over time (except in a severe downturn) and drag down your returns.
It's also fair to ask what has become of diversification, the supposed linchpin of a sound investment strategy. The answer is that diversification is alive and well, but the principle is more important for investors seeking to maximize their long-term returns rather than their short-term results. In the short run, individual stocks will move together. But in the long run, their returns are apt to diverge. For example, technology stocks performed disastrously for most of the first decade of the 21st century. But value stocks -- those selling at low price-earnings ratios or paying good dividends -- performed much better. The inflationary 1970s were good for commodities and bad for stocks, but the disinflationary 1980s put stocks on top as commodities sagged.
Stocks reward investors who can stomach short-term swings. If you want to insulate yourself from this volatility, you'll pay a price by holding assets that over the long haul will surely deliver lower returns. Stocks everywhere are selling at attractive prices and are likely to reward long-term investors. My advice: Diversify your stock portfolio globally and don't worry so much about day-to-day fluctuations.
Columnist Jeremy J. Siegel is a professor at the University of Pennsylvania's Wharton School and the author of Stocks for the Long Run and The Future for Investors.
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