Last week we convinced readers that qualitative anecdotes not only fail to provide professionals with actionable guidance around portfolio construction, but also can mislead investors from the true insight of market undercurrents.
We've found several articles that speak to the similarities between the current market environment (August 21 - 28) and the market decline that took place September 21st, 2011. This isn't so surprising given that there are several qualitative parallels to draw from:
- Concern over lackluster global growth
- Foreign economies as the bellwether to further sell-offs (Greece and the European Union in 2011, China in 2015)
- The implied volatility of S&P 500 index options, e.g. the VIX, spiked to over 40 (on September 26th, 2011 the VIX closed at 42.96 s whereas this past Monday the VIX reached a peak of 43.26)
- Weak data coming out of China indicated the second largest global is showing signs of slowing
Even a normalized price plot of US Equities and Foreign Equities could be used to craft a convincing story that the most effective allocation strategy given today's information should mirror the allocation strategy that succeeded in the fourth quarter of 2011.
However, not only is this information incomplete, it fails to reveal the compelling story of current market dynamics that can only be gleaned using a unique combination of intuitive visualization and robust analytics.
This Ain't Your Mama's Matrix
One way to explore the "similarity" of time periods is to compare each period's correlation between asset classes. We would expect similar risk / return dynamics of portfolios during times when assets within the portfolio had similar properties of co-movement.
Below are correlation statistics between asset classes on the 28th of September, 2011 and as of market close Friday, the 28th of August.
The correlation matrices show clear differences between the time periods. Furthermore, by using the portfolio-based analytics as the starting point of the analysis, the user can make cogent points about the current state of the market:
The risk on risk off behavior that drove investor allocations for several years does not effectively explain the current market environment. The dispersion of color in the 2015 correlation matrix indicates there are far more factors pricing portfolio assets, even after the market severe market decline experienced by global markets over the past week
While US Fixed Income served as the only means of mitigating risk for nearly the past 8 years, local currency Foreign Fixed Income has arisen as a new source of diversification during market decline
After a steep decline in global markets, there's no shortage of anecdotal, rationale-based advice for investors. At best, these types of insights provide a deeper understanding of market forces, yet fail to link insight and implementation. At worst, they mislead investors -- as we've demonstrated using this straw man we've seen in several place on the net -- by leading them to believe history will repeat itself, without adequate evidence to support such claims.
In fact, "times of similarity" should be demonstrated via asset class interdependence instead of anecdotal phenomenon and general economic trends. In future posts, we'll look at leveraging measures of temporal similarity to more effectively understand how to allocate portfolios with unknown future market outcomes.