Thursday, July 26, 2007

Technical Thursdays: Hedge Funds and Downside Correlations

Exactly two weeks from today, my next Market Forecast event for the New York Society of Security Analysts will feature a keynote address by Dr. Tobias Adrian of the New York Fed. The title of his speech is “Hedge Fund Tail Risk.” After reviewing an advanced copy of his presentation, I want to share with you a few thoughts on one of the issues that Dr. Adrian will address on August 9th that has a high application to today’s market: “Does tail risk of hedge funds increase in time of stress?”

As the charts above show and has been stated numerous times before, correlations are very high between and among sectors, styles, regions, countries, and, to some degree, other asset classes. What needs to be appreciated and what the above charts imply highlights a key aspect of Dr. Adrian’s speech: during times of stress, downside volatility accelerates in higher risk (but not necessarily higher beta) sectors*. This is precisely the risk that Dr. Adrian’s boss, NY Fed President, Timothy Geithner, worries about - When the brake becomes the accelerator. According to Dr. Adrian, the role hedge funds play in exerting downward pressure during times of stress is significant**.

Investment Strategy Implications

If technical analysis is worth its salt, then the current market decline will not metastasize into a contagion rout, which will trigger the tail risk (high downside volatility) event referred to by Adrain and Geithner. As noted in yesterday’s blog entry, the current correction got its start at an insignificant price point, thereby implying that the equity markets in the midst of yet another short and nasty correction. Moreover, as long as liquidity remains abundant, large and sustained market corrections tend to be mitigated.

It is advisable, however, that investors become keenly attuned to the risks of highly correlated markets that end up nearly eliminating the benefits of diversification and reducing downside risk minimization to the asset allocation decision. For there will come a day when the technicals are set up more completely than they are today for a major market decline. And liquidity may not be as abundant to save the day.

*For the styles in the left chart, the beta for the mid caps (MDY) is .98 and for the small caps (IJR) it's .95.
**Average hedge fund correlations are 32%; during time of stress the number jumps to 53%. In a related fact, Dr. Adrian points out that the correlations between hedge funds and investment banks are very high during times of stress (see third chart for a clear example of this point (IAI - broker/dealer ETF)

To view a larger version of the above charts, simply click on the images.


Grant said...

Hi. I've been reading your blog for the past few weeks and I think it's great. I am a bit confused though - when you refer to the current correction as having started at an 'insignificant price point', what exactly do you mean? If the correction had begun at or near one of the thousands (12000, 13000, 14000, etc) would that have made it significant? Or is the price point insigificant in terms of P/E valuation?


Vinny Catalano, CFA said...

Thank you, Grant. I appreciate the compliment. Glad you find the blog worth your while.

re the price point item: what I am referring to is a price point that the market has created through its trading and made into an important price point (versus something artificial like a round number). For example, the 200 day moving average or a support line that the market has bounced off of several times or a trend line that has been in place for a number of months or years.

Think of it this way, stock market action is like warfare in which ground is gained or lost. It is at those important junctures that determine how the war goes. The same with stocks. Price points are the battle lines that the market participants, over time, have made important.

Therefore, when the market moves from a price point that has no significance as I have described above, then the move tends to be of lesser sustained value.

(Note: this is all technical analysis stuff and does not involve fundamental issues like P/E.)

Hope this explains the issue better.

Best regards,