In recent years, the equity market has seen rapid expansion. The average daily trading volume has increased from 7 billion in 2019 to 10.9 billion in 2020 and 14.7 billion thus far in 2021. It has also been rewarding: The S&P 500 Index one-year return with dividends from March 2020 to April 2021 was 56.3%, the highest since 1980. With equity continuously going up, it might seem appealing to diversify within equity instead of other asset classes, in order to maximize returns and avoid diversifying the performance away. However, diversification in other asset classes, namely fixed income and commodities, is still as important as ever.
First, equity cannot continue to go up indefinitely. Second, there is little diversification within equity in down markets. The cyclically adjusted price-to-earnings ratio (CAPE) by Yale economist Robert Shiller is a valuation measure applied to the S&P 500 Index, where a company’s stock price is divided by the average of 10 years of earnings to smooth out sharp earning gains or drops, and adjusted for inflation. A high ratio suggests the market is overvalued and will eventually be corrected. The CAPE ratio median is 16 and has rarely been above 30 historically. It was at 32.56 in September 1929 before Black Friday, at 44.20 in December 1999 before the dot-com bubble burst and at 30.73 in February 2020 before the global pandemic. It stood at 36.94 as of April 2021.
Paradoxically, diversification within equity tends to work when it is not needed and to not work when it is needed. This week’s Chart of the Week illustrates this point, showing the correlation of monthly returns between the S&P 500 Index and other assets during normal versus volatile periods. A normal period is defined as when the monthly returns of the S&P 500 Index are one standard deviation below the 10-year average monthly returns, while a volatile period is when the monthly returns of the S&P 500 Index are one standard deviation over the 10-year average returns. The correlation of monthly returns between all equity markets is 0.52 in normal periods compared to 0.90 in volatile periods, meaning less diversification within equity markets is available during volatile times than normal times.
The chart also demonstrates that fixed income and commodities may be great diversifiers during normal periods. But not all fixed income and commodities offer the same protection during volatile periods.
Fixed Income:
For fixed income, high yield and emerging market bonds behave like equity, with a correlation of about 0.74 in the volatile period and 0.37 in the normal period. This is because they tend to hold lower-quality securities and during volatile periods, the companies that issued these securities may have difficulties meeting their obligations.
Alternatively, U.S. Treasurys, U.S. investment-grade bonds, mortgage-backed securities (MBS) and asset-backed securities (ABS) are nice diversifiers even in volatile periods. U.S. Treasurys and MBS have a negative correlation and U.S. investment-grade bonds and ABS have low correlation with the S&P 500 Index. This is because they tend to hold higher-quality securities, and MBS and ABS have physical assets as collateral, allowing them to better weather volatile periods.
Commodities:
In the case of commodities, the correlation between industrial metals and the S&P 500 Index tends to increase during volatile periods, reducing industrial metals’ effectiveness as a diversifier for equity. Since industrial metals include copper, tin and aluminum, they are very sensitive to the business cycle, unlike precious metals. Some companies use fewer industrial metals for building purposes during volatile periods, driving down demand and prices. Likewise, the global demand for energy tends to be lower during volatile times. And while oil prices are not only driven by the market, as OPEC can influence them through supply, these prices still tend to follow business cycles. OPEC’s oil exports account for approximately 60% of the total oil traded globally. When there is less demand for oil, OPEC can reduce supply and put upward pressure on prices. However, this process takes time and does not reduce the correlation between oil prices and the S&P 500 Index in volatile periods.
Agriculture, however, is a commodity that has a lower correlation with the S&P 500 Index. This is due in part to the fact that extreme weather and demand for biofuels can also impact agricultural prices. And because water shortages, climate change and population growth are not closely correlated with the market cycle, it makes sense that agriculture would correlate to a lesser degree with the S&P 500 Index than some other commodities.
Key Takeaway
In summary, while the equity markets are currently strong and still rapidly expanding, it may be tempting to invest in equities only. But the diversification protection offered by equities alone may be insufficient if markets become volatile. Additionally, the benefits of diversification between the S&P 500 Index and global equity markets have declined since the 1990s due to globalization, as companies are increasingly linked despite geographic distances.
The average 10-year correlation between the S&P 500 Index and the MSCI World ex-U.S. Index has increased from 0.45 in the mid-1990s to 0.85 in the 2020s. With CAPE at 36.94, the second-highest figure in history, it may be worth exploring a tradeoff between current equity performance and increased diversification with other asset classes, including fixed income such as U.S. Treasurys, U.S. investment-grade bonds, MBS and ABS, and commodities such as agriculture.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
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