Parallel Moves In Stocks, Bonds Signal Violent Market Swings Ahead

Price movements for a variety of risky assets have been remarkably correlated in January, and this may point to severe market upheavals ahead, when this relationship inevitably breaks down. In nine of 12 recent trading sessions, the S&P 500 Index (SPX), the yield on the 10-Year U.S. Treasury Note, and the price of U.S. crude oil moved pretty much in tandem, The Wall Street Journal reports, adding that this represented the highest degree of correlation among these assets in almost a year.

Meanwhile, the same article notes that periods of high correlation historically precede major turning points for the market, in which volatility often spikes. The table below summarizes a likely scenario that lies ahead.

Correlation May Signal Rising Risk

• Investors making similar bets on a broad range of asset classes
• Bets following broad themes, like global growth, and ignore fundamentals
• Positions face danger of unwinding rapidly once correlations break down
• Computerized trading models may unleash a flood of orders to buy or sell
• Huge moves in prices, up or down, are triggered by the flood of orders

^{Source: The Wall Street Journal}

Significance For Investors

In 2015 and 2016, worries about economic growth in China drove a simultaneous plunge in various asset prices, the Journal notes. Though stocks eventually rebounded, wrongly positioned investors suffered losses. Today, global GDP growth and central bank policy on interest rates appear to be the broad themes that investors are focusing on while making their bets.

High correlations in the price movements of oil, government bonds, and stocks typically occur when investors are particularly worried about the direction of monetary policy under central banks such as the Federal Reserve in the U.S., according to Denise Chisholm, sector strategist at Fidelity Investments. When these three asset classes fall together over the course of 12 months, history since 1974 suggests that stocks will rally during the next year, she told the Journal. Such simultaneous declines recently occurred in 2016 and 2018, she added.

Escalating Uncertainty

Nonetheless, Goldman Sachs observes that "global political uncertainty continues to climb, threatening economic and earnings growth as well as investor risk sentiment and equity valuations." Examples of this political uncertainty include, among others, the continuing U.S.-China trade conflict, the partial U.S. federal government shutdown, and Brexit, as Goldman observes in their most recent U.S. Weekly Kickstart report.

Indeed, the growing likelihood of a global recession is the top concern of more than 800 CEOs from across the world, according to a survey conducted by the Conference Board, a leading global business research group, and as reported in another Journal article. More worrisome yet, the survey was conducted before mounting pessimism about economic growth sparked a sharp stock market selloff in the fourth quarter of 2018. A year earlier, respondents had ranked the risk of recession only 19th out of 28 major concerns facing them.

Key indicators that measure heightened investor concern are giving off mixed signals. The CBOE Volatility Index (VIX), often called a fear gauge for the market, closed trading on Jan. 24, 2019 at a value of 18.89, down from a recent high of 36.20 in intraday trading on Dec. 26, 2018, but almost 65% above its reading a year ago and roughly 3% higher than its long term average, per YCharts.com. By contrast, the Investopedia Anxiety Index (IAI) recently registered high anxiety about the markets, but since has settled back to a neutral reading. The index measures the level of concern about the economy, the securities markets, and credit among our readers.

Looking Ahead

Active traders with short investment horizons are at particular risk when sudden market reversals occur. “People get into positions at all different times, but they all tend to go out the door the same time when volatility picks up,” as Tim Rudderow, who manages $1.5 billion at Mount Lucas Management LP, told the Journal. Sometimes, he added, “this creates opportunities." This is especially true for investors with a long-term focus.