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

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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%!

In other words, is it really a good sign for markets if different sectors are less correlated to the S&P 500? In particular, if the S&P 500 is hitting bull market highs the way it is here on Thursday, Feb. 3, 2011, why is it advantageous for individual sectors to move more independently? (Note: Not that anyone should claim that an average correlation of 0.72 is inherently weak. It's still quite strong.)

Simply put, we are certainly seeing a preference of developed world stocks over emerging-market equities in the near term. However, we're not yet seeing the end of the "Risk On-Risk Off" paradigm. For one thing, the riskiest sectors (high beta) have attracted the most assets and show the greatest relative strength. What's more, when total commodity ETFs like GreenHaven Total Commodity ( GCC) hit new 52-week highs at roughly the same time as total stock market ETFs like Vanguard Total Market ( VTI) hit new 52-week peaks, "Risk-On-Risk-Off" is still the name of the game.

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--Written by Gary Gordon.

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