Equity & Bond Correlations – Higher than Assumed?

It’s all a matter of perspective

January 2023 Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Using monthly versus daily returns when calculating correlations can change the perspective
  • Foreign stock markets and US bond markets were highly correlated to US stocks using monthly returns
  • Diversification benefits may have been significantly overstated using daily returns

INTRODUCTION

Investing can seem like an endless cycle of booms and busts. The markets and instruments may change — tulips in 1634, tech stocks in 2000, cryptocurrencies in 2021 — but the speculator’s drive to make fast money remains constant.

Yet once investors have lived through a bubble or two, we tend to become more conservative and cautious. The ups and downs, the peaks and crashes, combined with the trial-and-error process, help lay the foundation for our core investment strategy, even if it’s just the traditional 60-40 portfolio.

With memories of past losses, battle-worn investors are skeptical about new investing trends. But sometimes we shouldn’t be.

Once in a while, new information comes along that turns conventional wisdom on its head and requires us to revise our established investing framework. For example, most investors assume that higher risk is rewarded by higher returns. But ample academic research on the low volatility factor indicates that the opposite is true. Low-risk stocks outperform high-risk ones, at least on a risk-adjusted basis (read The Dark Side of Low Volatility Stocks).

Similarly, the correlations between long-short factors — like momentum and the S&P 500 in 2022 — dramatically change depending on whether they are calculated with monthly or daily return data (read Beta in Beta-Neutral Factors). Does this mean we need to reevaluate all the investing research based on daily returns and test that the findings still hold true with monthly returns?

To answer this question, we analyzed the S&P 500’s correlations with other markets on both a daily and monthly return basis.

CORRELATIONS USING DAILY RETURNS

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