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TheStreet Open House

Is the Risk-On, Risk-Off Trade Abating?

Stocks in this article: VTI GCC

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage. The opinions expressed are those of the author and do not represent the views of TheStreet or its management.

NEW YORK ( ETF Expert) -- The idea that different assets move independently of one another over time is the cornerstone of true diversification -- and yet it hasn't truly existed since 2007. In fact, most stocks, bonds, commodities and currencies have all fallen or risen together; the only differences have been matters of degree, not direction.

With that said, research group ConvergEx recently suggested that the "Risk-On-Risk-Off" trade may be fading. The evidence to support this possibility included: (1) precious metals moving independently of other financial assets in January, (2) the Australian dollar moving independently of the euro-dollar currency pair in the fourth quarter of 2010 and (3) sector correlation coefficients with the broader S&P 500 averaging 0.72, the lowest number since April 2010's 0.78.

Admittedly, strategists would relish the possibility of a prominent return for noncorrelating assets. Finding investments with unique cash flow qualities and/or capital appreciation potential -- each zigging and zagging with no discernible relationship to other assets in a prospective portfolio -- that would be the holy grail of construction!

Unfortunately, the excitement is premature. Consider the Australian dollar mentioned earlier. The fact that the relationship between the euro and the Australian dollar had evaporated in the three months that made up the forth quarter may have been promising on the surface. However, the Australian dollar is the highest-yielding developed world currency in the Risk-On "Carry Trade." If worldwide investors see little reason to fear appreciation in the greenback, they borrow at negligible interest rates and invest in the higher-yielding Australian dollar or any other risk asset.

It follows that if the "Risk-On-Risk-Off" scenario were truly abating, we would see a negligible relationship between the dollar and the Australian dollar. Alas, the relationship over the last six months remains at an inordinately high correlation coefficient of -0.75. Clearly, there's little evidence that carry traders have abandoned the "Risk-On-Risk-Off" world.

Now let's consider the fact that industry sectors recently had their lowest collective correlation to the broader S&P 500 in 16 months. The last time the average correlation of industry sectors to the S&P 500 slipped below 0.80? April 2010. It may have occurred to the researchers at ConvergEx that this is also the last time that the U.S. stock market corrected by more than 10%!

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