A Free Lunch in a Perfect Storm
When it comes to stock market risk and returns, finance professor Nejat Seyhun says we can have our cake and eat it, too.
ANN ARBOR, Mich.—As we welcome 2012, it is a good time to take stock of the lessons learned in the rollercoaster market of 2011.
The year ended on a mixed note. The Dow Jones Industrial Index was up about 6 percent, the S&P 500 index stayed pretty much flat, and the Russell 2000 was down about 4 percent for the year. Overseas, European and Asian stocks fared worse. MSCI Europe ETF and iShares S&P Asia 50 Index ETF were both down about 15 percent.
Investors' concerns in 2011 focused on existential issues: possible collapse of the euro, widespread European sovereign and bank defaults, and a potential global depression. Investors also worried about disorderly Greek, Irish, Portuguese, Italian, and Spanish defaults. A new term was coined—private-sector involvement—to refer euphemistically to private investors' losses on their European sovereign-debt holdings, a concept that would have been unthinkable a year earlier. Consequently, the prices of European periphery sovereign debt plummeted and yields skyrocketed.
Against this doomsday scenario, a surprising bright spot was the U.S. economy. The economic picture in the United States steadily improved during the year. GDP growth rose from 0.4 percent in the first quarter to 1.8 percent in the third. Retail sales increased about 8 percent year-on-year and unemployment declined from 9 percent to 8.6 percent. Forecasts of S&P 500 stock earnings in 2012 surpassed $100.
Investors reacted to these mixed signals with full-speed-ahead gusto one day and full-speed reverse the next. Market commentators coined another term: risk-on, risk-off. One day, investors worried about global depression; the next day, they worried about missing a golden opportunity to make a lot of money.
Market volatility also took a ride on the rollercoaster. The fear gauge, the CBOE VIX index, started the year around 18 percent, reached almost 50 percent in early August, and ended the year around 23 percent. Increasing market volatility also led to sharp increases in correlations. Cross-correlation of the returns for stocks in the S&P 500 index rose from about 30 percent at the beginning of the year to above 80 percent by year end.
Similarly, the correlation of gold and the stock market went from near zero to more than 40 percent during 2011. In contrast, investors viewed U.S. Treasuries as the only safe harbor. Increasing demand for U.S. Treasuries saw yields on the 10-year T-note decline from 3.3 percent to 1.9 percent by year end. Meanwhile, the correlation between 10-year T-notes and S&P 500 index increased to -75 percent.
The fact that the 10-year T-note yield has declined to 1.9 percent is nothing short of amazing. At this rate, the real yield on 10-year U.S. Treasuries is -7 basis points. Hence, investors are willing to accept a loss in real terms over the next 10 years for the privilege of knowing that their losses will be limited. This indicates the depth of investors' fears.
Investors also typically think about increasing correlations as a reduction in risk management opportunities. When the correlations of individual stocks within S&P 500 increased to more than 80 percent, it is as if the entire market is composed of a single stock. With good news about the U.S. economy, everything goes up. With bad news about Europe, everything goes down. There is no place to hide and no way to manage risk.
However, this line of thinking is not correct. While it is true that risk management through stock selection has declined, risk management using asset classes has certainly increased. In fact, we can have our cake and eat it, too.
Take the S&P 500 stocks and the 10-year Treasury Notes, for example. The fact that the correlation between these two assets has increased to -75 percent means that there are excellent risk management opportunities. If investors currently invest all of their wealth in the 10-year T-note, they are looking at an annual return of 1.9 percent, with an annual standard deviation of about 8 percent.
Here comes the risk management part. Suppose that instead of investing all of their wealth in the U.S. Treasury, investors allocated about half in U.S Treasuries and half in S&P 500 stocks. My calculations show that given the -75 percent correlation between these two asset classes, this mixed portfolio has exactly the same risk as a 100 percent investment in 10-year U.S. Treasuries, with a standard deviation of about 8 percent. The expected return, however, now nearly triples to 5.5 percent. The extra 3.6 percentage-point return with no increase in risk is the free lunch the stock market is offering us. There are similar excellent opportunities to manage risk using gold, oil, and the stock market.
Nejat Seyhun, the Jerome B. & Eilene M. York Professor of Business Administration; Professor of Finance
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