A Free Lunch in a Perfect Storm

As we welcome 2012, it is a good idea to take stock of the lessons of the roller-coaster stock market of 2011. The year ended on a mixed note.  The Dow Jones Industrial Index was up about 6%, S&P 500 index pretty much flat and Russell 2000 down about 4% for the year. Overseas, European and Asian stocks fared worse.   MSCI Europe ETF and iShares S&P Asia 50 Index ETF were both down about 15%. 

Investors’ concerns in 2011 were about existential issues.  They worried about a possible collapse of euro, wide-spread European sovereign and bank defaults, and possible global depression.  Investors also worried about disorderly Greek, Irish, Portuguese, Italian and Spanish defaults.  A new term was coined, Private Sector Involvement (PSI), to euphemistically refer to private investor’s losses on their European sovereign debt holdings, a concept that would have been unthinkable a year earlier.  Consequently, the prices of European periphery sovereign debt plummeted and their yields skyrocketed. 

Against this dooms day scenario, a surprising bright spot was the U.S. economy.  The U.S. economic picture steadily improved during the year.   The U.S. GDP growth rate rose from 0.4% in the first quarter to 1.8% in the third.  Retail sales increased about 8% year-on-year and unemployment declined from 9% to 8.6%.  Forecasts of S&P 500 stock earnings in 2012 surpassed $100.

Investors reacted to these mixed signals with full-speed ahead one day and full-speed reverse the next day.  Market commentators coined another term, risk-on, risk-off.  One day, investors worried about global depression; the next day, they worried about missing a golden opportunity to make a lot of money. 

Market volatility also went on a roller coaster.  The fear gauge, CBOE VIX index, started the year around 18%, reached almost 50% in early August, and ended the year around 23%. Increasing market volatility also led to sharp increases in correlations. Cross-correlation of the returns for stocks in S&P 500 index rose from about 30% at the beginning of the year to above 80% by year end.  Similarly, correlation of gold and stock market went from near zero to over 40% during 2011.  In contrast, investors viewed the U.S. Treasuries as the only safe harbor.  Increasing demand for the U.S. Treasuries saw the yields on the 10-year T-Note decline from 3.3% to 1.9% by year end.  Meanwhile, the correlation between 10-year T-Notes and S&P 500 index increased to -75%.

The fact that the 10-year T-note yield has declined to 1.9% is nothing short of amazing.  At this rate, the real yield on the ten-year U.S. Treasuries is -7 basis points.  Hence, investors are willing to accept a loss in real terms over the next ten years for the privilege of knowing that their losses will be limited.  This indicates the depth of investors’ fears. 

Investors also typically think about increasing correlations as a reduction in risk management opportunities.  When the correlations of individual stocks within S&P 500 increased to over 80%, it is as if the entire market is composed of a single stock.  With good news about U.S. economy, everything goes up.  With bad news about Europe, everything goes down.  There is no place to hide and no way to manage risk. 

However, this line of thinking is not correct.  While it is true that risk management through stock selection has declined, risk management using asset classes has certainly increased.  In fact, we can have our cake and eat it too.

Take the S&P 500 stocks and the 10-year Treasury Notes, for example.  The fact that correlation between these two assets has increased to -75% means that there are excellent risk management opportunities.  If an investor currently invests all of her wealth in the ten-year T-note, she is looking at an annual return of 1.9% with an annual standard deviation of about 8%.  Here comes the risk management part.  Suppose that instead of investing all of her wealth in the U.S. Treasury, our investor allocated about half in the U.S Treasuries and half in S&P 500 stocks.  My calculations show that given the -75% correlation between these two asset classes, this mixed portfolio has exactly the same risk as 100% investment in ten-year U.S. Treasuries, with a standard deviation of about 8%.  The expected return however, now almost triples to 5.5%.   The extra 3.6 percentage point return with no increase in risk is the free lunch stock market is offering us.  There are similar excellent opportunities to manage risk using gold, oil and the stock market.

May 2012 bring you all many free lunches and other presents.