Monday, March 21, 2011

Markets Back in Lockstep as Risk Bets Return

Markets Back in Lockstep as Risk Bets Return

Just when markets seemed headed back to normal, the "risk on/risk off" trade has come roaring back.
Across financial markets, trading patterns more commonly seen in 2010 are returning. Stocks and the dollar are consistently moving in opposite directions, as are stocks and Treasury securities.

It is a trading pattern that was common for much of 2010 as investors swung in and out of markets en masse–buying "risk on" investments like stocks when they felt brave, and "risk off" assets such as Treasurys and the dollar when they wanted safety.
 
That pattern broke down earlier this year, in what some had seen as a return to normalcy. But the tensions in the Middle East and nuclear crisis in Japan have seen it return, frustrating investors who are seeking to trade on fundamental factors instead of headlines. The U.S. and coalition military strikes in Libya that began this weekend could become yet another flashpoint for worry.

"We are just plagued today with the lack of long-term trends, and it's because of people reacting to the issues of the day,"said Jim Sarni, managing principal at Los Angeles money manager Payden & Rygel. "You get long-term investors trying to anticipate what hedge funds are going to do—and not do— so they don't get caught on the train tracks."

Many investors think markets could be at risk of knee-jerk moves for the foreseeable future, a result of the increasingly volatile nature of global markets, and liquidity being pumped into markets by the Federal Reserve.

In a crisis, according to the market adage, all assets are correlated, meaning that ordinarily unrelated investments suddenly swing up and down as if they are connected, as investors shed risk and hunker down. The latest episode has been a case in point.

The U.S. dollar and stock market have increasingly moved in opposite directions, in an example of what analysts call a negative correlation. That link persisted for much of 2010, but had faded dramatically earlier this year, according to data compiled by Nomura Securities International.

Theoretically, the dollar and U.S. stocks shouldn't have much of a relationship. The value of the dollar affects corporate profits, but it doesn't typically have a big impact on the health of U.S. companies and the economy. But in the risk-on/risk-off era, the dollar has become a haven to which traders retreat when they are in risk-off mode.

"For the time being, at least, it looks like we are back to risk-on/risk-off," Nomura currency strategist Anish Abuwala said.

Similarly, a negative correlation between stocks and 10-year Treasury notes, which peaked last summer, has returned, according to data compiled by research firm Birinyi Associates Inc. That is a sign that investors are dumping stocks and buying Treasurys when they flip the risk-off switch. The negative correlation between stocks and Treasurys last week was its highest since last September, according to Birinyi.

In another sign of risk aversion, the average correlation of individual stocks to the broader Standard & Poor's 500-stock index last week rose to its highest level since December, according to Birinyi data. In February, that average correlation had dropped to its lowest level in four years, a period that extends well before the financial crisis.
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Still, many correlations aren't as strong as they had been. And some market relationships have changed completely. Some are taking that as a sign that the return to risk on/risk off trading may be fleeting, and that fundamentals are still playing a role in investing decisions.

"Our belief is that we are still migrating away from the risk-on/risk-off mode," said Matt Toms, head of U.S. public fixed-income investments at ING Investment Management. "We think correlations will continue to decline."

Stocks and oil prices, for example, no longer move in lock step as they did for much of last year. Then, both were considered speculative plays that investors bought when feeling frisky and sold when gripped by anxiety.

Lately, the stock-oil relationship is on the rocks. Their correlation has turned slightly negative, according to Birinyi data, as investors have worried that higher oil prices could choke off the global economic recovery.
Gold and stocks were strongly correlated last year, too, but have almost no relationship this year, according to Birinyi data.

More broadly, risky assets have shown some resilience in the face of a barrage of downbeat news, potentially a sign that investors are finally able to look past the headlines. The Dow Jones Industrial Average, at its worst, fell only about 6% from its Feb. 18 high. Junk bonds suffered an even milder decline, losing just 1% in price during that time.

A return to fundamentals would be welcome news to many investors who have been frustrated by the unpredictable and seemingly irrational nature of market moves in recent years.

One motivation for investors parking money in apparently safe bonds and dividend-paying large-cap stocks has been an aversion to being mowed down in riskier trades by hedge funds, proprietary trading desks and fast-trading computers using exotic algorithms.
The rise of exchange-traded funds, which buy and sell entire sectors or markets at a time, has tended to push correlations higher, making it harder to judge investments on old-fashioned criteria, such as whether they are expensive or cheap.
"Non-professional investors feel they don't get a fair shake, that they have no capability whatsoever to understand the forces that are really driving the market," said Dan Genter, chief executive and chief investment officer of RNC Genter Capital Management in Los Angeles. "The fact is, they're right."
Mr. Genter, like Mr. Toms, thinks fundamentals will gain power in financial markets, as the memories of recent crises fade. But both agree with the skeptics that over the longer haul, the trend is toward greater correlations and away from fundamentals.
Dramatic swings may also have been sharpened in recent years by the flood of money steadily being pumped into the market by the Federal Reserve. That easy cash almost forces investors to take big risks, although they recoil from them at the first sign of danger.
"The end of quantitative easing is going to be a pivotal event for the risk-on/risk-off mentality," said Clark Yingst, chief market analyst for brokerage firm Joseph Gunnar. "The whole thing has been facilitated by QE."
Write to Mark Gongloff at mark.gongloff@wsj.com

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