Statisticians spend a great deal of time debunking the notion that “correlation implies causation.”  The idea being that just because two data series are correlated does not necessarily mean one causes the other, or vice versa.  This is not a new topic to readers of Abnormal Returns.  There has been a great deal of chatter in the financial media and blogosphere about the long march towards higher correlations.

Josh Brown at The Reformed Broker had a nice post yesterday noting the “pandemic” that is global correlations.  He writes:

This doesn’t mean to ignore geography when planning a portfolio.  No, the takeaway is not to rely on geography – because when the going gets rough, it’s all one market.  On top of that, even in periods of calm we are headed there anyway – globalization of trade means globalization of stocks in the long run.

In regards to the financial markets we should also recognize that correlation is not destiny.  For instance everyone recognizes that small cap and large cap US stocks are highly correlated.  Since January 2001 through August 2011 the Russell 2000 and S&P have a correlation of 0.89 based on monthly returns.  Pretty high by most standards.  Over this same time period $IWM returned 71% versus 12% for $SPY.  Although these two asset classes are clearly correlated their returns can (and will) diverge over time.  In short correlation is not destiny.

Another way to think about this is via a thought experiment.  Let’s take the daily returns of the S&P 500 for the past year and simply add 1 basis point to each day’s returns.  $SPY over this time period returned 7.7%.  Our modified S&P 500 would have returned 10.4%.  However the correlation between these two return series is by definition 1.00!  Two highly correlated assets can see their returns diverge over time.

The bottom line is that correlation is an important concept to understand when it comes to asset class returns.  There is no doubt that stocks and sectors with the US and global markets have been getting more correlated over time.  This does not mean that certain stocks, sectors and markets cannot outperform (or underperform).  Higher correlations simply mean that the relative performance along the way is going to get masked by overall market movements.  Correlation does not imply causation, nor does correlation imply destiny either.

This content, which contains security-related opinions and/or information, is provided for informational purposes only and should not be relied upon in any manner as professional advice, or an endorsement of any practices, products or services. There can be no guarantees or assurances that the views expressed here will be applicable for any particular facts or circumstances, and should not be relied upon in any manner. You should consult your own advisers as to legal, business, tax, and other related matters concerning any investment.

The commentary in this “post” (including any related blog, podcasts, videos, and social media) reflects the personal opinions, viewpoints, and analyses of the Ritholtz Wealth Management employees providing such comments, and should not be regarded the views of Ritholtz Wealth Management LLC. or its respective affiliates or as a description of advisory services provided by Ritholtz Wealth Management or performance returns of any Ritholtz Wealth Management Investments client.

References to any securities or digital assets, or performance data, are for illustrative purposes only and do not constitute an investment recommendation or offer to provide investment advisory services. Charts and graphs provided within are for informational purposes solely and should not be relied upon when making any investment decision. Past performance is not indicative of future results. The content speaks only as of the date indicated. Any projections, estimates, forecasts, targets, prospects, and/or opinions expressed in these materials are subject to change without notice and may differ or be contrary to opinions expressed by others.

Please see disclosures here.

Please see the Terms & Conditions page for a full disclaimer.