Regressing to the Mean: Asset Values Returning to Low Correlations

By Rob Stein

Asset values are finally marching, once again, to the beat of their own drummers. For portfolio managers and investors alike, this is a welcome change of tune.

Among the many investing challenges of the past few years—beyond the aftermath of a near-meltdown of the financial system and a global economy that went into a deep recession—was the high degree of correlation among different assets. Assets moved in tandem, whether in lockstep or with inverse moves, based largely on “risk on/risk off” investment decisions. Concerned about Europe? Sell stocks, buy bonds. Think the EU ministers will reach a deal? Buy stocks, sell bonds. Nowhere in those decisions was there much thought given to the fundamentals.

Fortunately, that is now changing. Asset values are regressing to the mean as more normal economic influences are being exerted on stocks, bonds, and commodities.

The good news for investors and managers is that making a judgment call or a forecast is hopefully no longer an “all or nothing” proposition. In other words, a portfolio manager can be spot-on about one asset but off about another and still make money. In the days of high correlation, if a manager got one call wrong, virtually every call was wrong. This was extremely challenging for tactical managers as well as firms like Astor.

At Astor, our expertise is economics-based active management. By analyzing various indicators, we determine the state of the economy right now (expansion, peak, contraction, or trough) and invest accordingly. Our models work best when asset correlations follow normal, historic patterns. Low correlation also helps promote portfolio diversification, with strong performance in one area offsetting a weaker performance or even a loss in another. A manager doesn’t have to be 100 percent right to make money. And that, after all, is the objective of an active manager: to create a portfolio that makes money, whether the market rallies or falls.
Looking ahead, as we at Astor Asset Management analyze our investment holdings we will take into account the lowering correlation among asset classes, which we feel is good news for a diversified portfolio such as ours. With asset values reverting to the mean, we will continue pursuing our goal of generating solid, risk-adjusted returns.

Further, as we evaluate our investment decisions for the upcoming quarters, we will continue to watch closely the apparent disconnect in the economic data between GDP and employment. Normally, these two indicators move in tandem and for obvious reasons: When the economy is growing (as evidenced by positive GDP numbers) then employment numbers should increase, while the unemployment rate declines. We’ve seen pretty good jobs numbers lately, but relative weakness in GDP.

The outlier appears to be job growth. The seasonally adjusted unemployment rate was 8.3% in February, down from 8.5% in December and 9.0% in February 2011. Such apparent improvement in the employment picture may have more to do with the participation rate (fewer people in the workforce), than actual gains in the number of employed people.

For the employment picture to show an improvement of that magnitude, one would expect better economic growth than the 3.0% GDP gain for Q4 2011 and 1.8% in Q3 2011. Therefore, GDP numbers for 2012 bear close watching to see if the economy will really gain traction or if things will start to slip. We stand by our determination that the economy has not been giving indications of sustainability in either direction. Now, it appears 2012 will bring us to the crossroads of either expansion or a double dip. No more muddling through.

So what should we hope for, as one investor asked me recently. Rally? Pullback? Root for the portfolio to make money--and for asset value correlations to continue the move toward rationality, based on fundamentals.

All information contained herein is for informational purposes only. This is not a solicitation to offer investment advice or services in any state where to do so would be unlawful. Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve results that are similar to those shown. Please refer to Astor's Form ADV, Part 2 for additional information and risks. Analysis and research are provided for informational purposes only, not for trading or investing purposes. Astor and its affiliates are not liable for the accuracy, usefulness or availability of any such information or liable for any trading or investing based on such information. There is no assurance that the Astor’s investment programs or funds will produce profitable returns, you may lose money. (500001-226)