Nothing rains on your parade like a new deadly pathogen taking the world by force. Today there is Coronavirus and Correlation. One day everything is fine, the markets are reaching all-time highs, and the next minute there’s an empty space where your favorite no-name pasta used to be. You’re now wondering if good old COVID-19 is going to seep through your windows and start turning everyone inside out.
We can apply the same view to the markets. If we look at SPY we can see that the pasta has left the shelves too…
CORONAVIRUS AND CORRELATION IN THE MARKETS
How about our Australian friends?
Ahem, surely there is some pasta somewhere… Germany?
As you can see there is clearly correlation regarding coronavirus. Is the world over-reacting? Maybe, I’m definitely no virologist. But what I do know is that just like the pasta aisle of your preferred grocery store, not all of them are empty.
THERE ARE SAFE HAVENS
While everyone is freaking out in most parts of the world life in Argentina has continued as normal. In fact, there isn’t a report of infection here and the first report of infection on the entire continent was only reported last week. People are going on about their lives and have more permanent and pressing issues to keep them up at night, like inflation.
Why does this matter?
One word. Correlation. Correlation tells us how assets move in relation to each other. To give you a brief explanation:
- Positive: positive correlation of assets tells us what percentage of time they moved in the same direction.
- Negative: negative correlation of assets tells us what percentage of time they moved in the opposite direction.
- No correlation (zero, 0, 0%): tells us the returns are completely uncorrelated.
And just like Argentina, there are markets and return streams that are minimally affected by Coronavirus…
Let’s have a look at the positively correlated markets compared to the S&P 500 over the last month (middle column).
As you can see, the world’s markets basically all move virtually in the same direction. When one goes down, they all go down. You might think you have a diversified portfolio of ETFs or stocks across the world’s markets but in reality, you don’t. Germany, Australia, the USA, France, China, they’re all the same.
But hold on a minute, let’s take a closer look at the negative correlation (right column). What do we see? Every single item is a foreign exchange pair (FX). The world’s markets all move the same way and are highly correlated, but FX seems to move inversely and is less correlated.
WHY IS THIS IMPORTANT?
Well generally if you are buying the world’s markets in say an ETF, like above, you are doing exactly that, buying, that is to say you are only going long. If you attempt to go short, well, I wish you the best of luck because you’re probably going to have a bad day. FX is a different bag though. In general, FX is mean-reverting and that means it’s smart to buy and sell. So when the S&P 500 is going up, and our FX pairs are going down, we can short and still profit.
HOW YOU CAN PROTECT YOUR DOWNSIDE
You need to invest in return streams that aren’t correlated. You need a hedge. When your stocks are plummeting you need something to keep you afloat.
Something like our Pacific Strategy offers nearly zero correlation as well as decreased risk compared to the world’s markets.
This is a correlation table comparing our strategy against the world’s markets over the last 10 years. But what about in the last month when the markets have been dumping?
This is a correlation table for February 2020. While the S&P 500 lost 8.23% our Pacific Strategy only lost 0.53%. We can also see that in all comparisons our return stream correlation to those markets is low to zero and we had the lowest maximum drawdown.
I have a feeling it’s going to get worse before it gets better.