Note: The following article is an excerpt from the Third Quarter 2010 Letter to Investors from Artemis Capital Management LLC published on September 30, 2010. PDF Download
The summer of investor discontent was made glorious by the sun of quantitative easing as the equity markets finished their best September since 1939, largely due to expectation for further monetary stimulus. Earlier this month the Federal Reserve signaled its intention to renew its Treasury bond purchase program (known as Quantitative Easing 2 or QE2) sending the markets up, the dollar down, and our trading partners into a frenzy. In this brave new normal our monetary policy has somehow managed to make any asset yielding above 1% look sexy while sparking a global race to depreciate every globally traded currency. While the noble intention is stabilization and job growth the Federal Reserve is inadvertently throwing the global monetary world into complete disarray. The correlations (implied and realized) of asset classes are at multi-decade highs negating the benefits of diversification and mystifying even the most seasoned investors. In addition volatility surfaces steepened significantly over the quarter with the high volatility skew emblematic of a growing distrust of the prevailing equilibrium. There is a definitive connection between current monetary policy, unusually high correlations, and the historically steep volatility surface. Even as the domestic equity markets rise, the volatility and correlation markets are flashing signals of increased systemic risk seething under an innocuous surface. The following letter uses detailed quantitative analysis to make this case, but as you will see, the simple metaphor of selling pineapples in a Hawaiian farmer’s market may suffice to understand why risk is increasing exponentially in today’s global economy.
Rise of the Correlations: The paradox of the economic recovery is a phenomenon whereby different asset classes are moving in sync at highest levels in decades, making diversification futile for professional and retail investors alike. Correlation is a statistical measurement used to determine how closely the prices of different securities move in tandem and is directly related to volatility. Correlations are an important tool to test our trust in the market simulacrum because they provide a way to measure randomness. High correlation in markets can be described as a representing a lack of randomness in the price discovery mechanism. When markets become less random, paradoxically, they become riskier but also attractive for arbitrage opportunities.