Wednesday, 25 July 2012

More stumbling around correlations

Continuing with correlation, I noted in my last post that the correlation over a historical 1-year rolling period seems far too volatile to look like a stable relationship for two assets (stocks and bonds) to look weakly correlated.

From 2002 to mid-2012, the trailing 365 day correlation between equity and bonds looked like this:
 Which begs the question, are these two assets really good diversifiers if their correlation varies so much? I observed in the previous post (and independently concluded by turckerreport), over shorter-time frames, correlation is essentially useless for trading, since the relationship swings from one extreme to another.

And I know over 10 years, correlations tend to stay low. So I tried running the data over longer timreframes: 2-year and 3-year periods.

Looking at 2 and 3 year correlations suggests that correlations are more stable over 2 to 3 years, swinging less from one end to another. So it seems for now at least, I needn’t rehaul my portfolio of unit trusts, as long as I’m looking at a 3yr holding period.

The question then becomes, what causes correlations to rise and fall?
The literature I skimmed through by MSCI Barra and one Li Lingfeng suggest inflation expectation and interest rates have something to do with it. 

Although the exact nature of the relationship between these two forces is beyond my limited grasp of economics. Plus, some of the terms in there are as complex as the names that attributed to them. For example:

“Scruggs and Glabadanidis (2001) strongly reject models which impose a constant correlation restriction on the covariance matrix between stock and bond returns. Fleming, Kirby and Ostdiek (1998) find a strong volatility linkage across stock-bond-bill markets, and attribute it to the information flow in these markets. However, they associate the information flow with volatility and do not identify the exact information that causes the comovement. David and Veronesi (2001) show that the uncertainty about inflation and firm earnings explains some of the changes in the variances and covariance of stock and bond returns.”
I mean, I know it’s English, but it might as well be in Latin because that I have very little clue as what are the implications of the conclusions stated in the paragraph. 

Yes, I took a few economics courses as a freshman, but freshman economics and investing are two different things altogether. And as much as I enjoyed microeconomics 101, macroeconomics (it was a Keynesian view of economics I believe) was not as accessible to me, and I had a tough time even grasping at straws. 

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