Keeping Your Balance in a Rebooting Economy
March 31, 2023
Keeping Your Balance in a Rebooting Economy
Go ahead and put all your eggs in a single basket, Mark Twain once quipped, but you’d better watch the basket.
Since the eggs in your equity market basket are vulnerable to unforeseen events, such do-it-yourself guard duty is impractical. A better plan is to add baskets, either in the form of asset classes or individual securities.
In other words, to diversify.
But as the post-pandemic economic recovery gathers steam amid a tidal wave of monetary and fiscal stimulus, investors are finding it unusually unappealing to diversify into traditional “safe haven” assets like cash and bonds.
That conundrum is attributable to a rare (and hopefully fleeting) confluence of economic forces: demand-pull inflation caused by reawakened consumer demand for goods and services, and cost-push inflation caused by shortages and supply-chain bottlenecks that push up labor and raw materials prices.
One strategy for dealing with an out-of-balance economy is to build portfolios comprised of low or negatively correlated assets, i.e., those that move in the same direction but not by the same amount, or if you don’t mind driving with one foot on the gas and the other on the brake, those that generally move in opposite directions.
Correlation is measured on a continuum from +1 to -1; the higher the number, the more synchronized the movements. According to Guggenheim Investments, the correlation between the S&P 500 and baskets of commodities and real estate investment trusts over the last decade was 0.55 and 0.70, respectively, indicating that metals and buildings might offer a measure of diversification. Conversely, currencies and investment grade bonds were negatively correlated to U.S. stocks.
Of course, asset classes themselves aren’t the only kind of investment “basket.” Individual stocks that regularly move in the same direction by nearly the same amount also could be considered a basket of sorts. That’s why it’s useful to know the correlations between stocks you already own and among those that you might consider adding.
Begin by visiting portfoliovisualizer.com/asset-correlations and entering ticker symbols for stocks whose correlations you’d like to measure. Next, type in start and end dates (choose a multi-year period, up to the present), a “Correlation Basis” (annual returns are most meaningful for long-term investors), and hit “View Correlation.”
Using those criteria, I found only a modest correlation between Apple and Microsoft shares, and a relatively low (but still positive) correlation between Apple and Disney.
Those results demonstrate that it’s possible to gain meaningful stock-specific diversification even in an environment that seems to be pushing overall valuations to worrisome extremes.
It is important to note that correlations can change. For example, when the Federal Reserve System is cutting rates, equity and fixed-income prices tend to move in the same direction. But if rates already are low and likely to rise as the economy recovers — like now — the stock-bond correlation often will be negative. The portfolio visualizer site allows users to input various combinations of correlation basis and time periods; choose ones that seem most relevant to your objectives.
Finally, resist the urge to view those nonexistent yields on cash with derision. Cash is not trash, even when rates are below inflation. For all its lack of pizazz, cash still represents valuable buying power to scoop up stocks on the cheap in the wake of market corrections.
Which, given an economy still searching for balance in the later stages of a once-in-a-century health crisis, might be only a matter of when, not if.
