Reply #42: Why investors were not as diversified as they had thought [View All]

[Ghost Dog]

http://www.economist.com/finance/displaystory.cfm?story_id=8829603
Buttonwood
We all fall down

Mar 8th 2007
From The Economist print edition
Why investors were not as diversified as they had thought

DON'T put all your eggs in one basket. Investors are taught at stockmarket elementary school that the secret to avoiding financial disaster is to make sure they diversify their portfolios.

But when markets plunged on February 27th shelter was pretty hard to find. First China fell, then European markets, then Wall Street. Emerging markets suffered. Corporate-bond spreads widened (in other words, their prices dropped). Oil declined. Even gold, a supposed “store of value”, took a hit. Only the yen and government bonds gained ground.

This marching-in-step has been described by Henry McVey, a Morgan Stanley strategist, as a “market of one”. Diversification did not bring the benefits that investors might have expected.

Perhaps it should not be too surprising that, according to Merrill Lynch, over the past five years the Russell 2000 index of small American companies has a 94% correlation with the S&P 500, the main Wall Street index. More alarmingly, international stockmarkets have not offered any diversification either: they have shown a 95% correlation. Yet more startling are the figures showing that hedge funds have recorded a 94% link with shares. Even property has been following Wall Street 81% of the time.

Why should this be? The obvious explanation is the much-touted “excess liquidity” that has been driving up one asset price after another. There is a healthy debate about how to measure this liquidity, or indeed whether the term has any real meaning. But most people agree that the savings surpluses in Asia and the oil exporters have played an important part in fuelling financial markets. JPMorgan estimates that global liquidity increased by $3.9 trillion between 2002 and 2006, of which around 50% came from Asia and 40% from the oil producers.

The bulk of this money went at first into risk-free assets such as Treasury bills and bonds. That drove down the yield on such assets. So other investors were then naturally tempted to look elsewhere for higher returns.

Meanwhile, pension funds have been trying to reduce the bets they have made on shares. This combination has unleashed a “chase for yield” as any asset with an above-average income (or which offered the prospect of above-average returns), has been driven up in price. More speculative investors have been tempted to borrow at the risk-free rate and invest in risky securities, one version of the talked-about “carry trade”.

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