When markets are highly correlated, it can be tough to stay diversified. If various markets are moving up or down in unison, that can quickly cause your risk and volatility to get out of hand. That’s why we’ve started keeping an eye on two statistics that illustrate how easy or difficult it has been to stay diversified in the futures markets: the risk on/risk off trade, and market correlations.
October turned out to be one of the most “normal” months this year in terms of our count of the risk on/risk off dynamic. (If you need a refresher, we broke down the risk on/risk off trade earlier this year.) The month contained zero “risk on” days and only one “risk off” day. Unfortunately, the lack of big single-day multi-market swings didn’t translate into better CTA performance, showing that while those individual days may hurt, diversification doesn’t help much when the trends are reversing in multiple markets. (Disclaimer: past performance is not necessarily indicative of future results.)
Risk On = average gain of over 1% for “risk” assets; Risk Off = average loss of over -1% for “risk” assets.
What about the overall market correlations? As a refresher, correlation is a statistical measure of how interrelated two sets of data are. A correlation of 1.00 would mean that the markets move in lock-step, and a correlation of -1.00 means that they always move in opposite directions. For diversification value, what we’re looking for is non-correlation (a correlation of 0.00), which would mean that the two markets are behaving as though they are completely unrelated.
The overall market correlation in October was in line with the previous two months, coming in at 0.289 (based on the absolute value of all market correlations). The only significant change from previous months was a slightly higher correlation between metals and energies, as both spent the month on a downward trend. Cotton moved somewhat in line with stocks (and opposite treasuries) for the second month in a row, showing more susceptitilibyt to overall market trends than other softs. As usual, the Japanese Yen and natural gas stood out within their respective market sectors as excellent diversification plays.
