Global stocks are in step, sending managers to arbitrage – Part 2


By Daniel Hauck and Alexis Xydias NEW YORK/LONDON, Bloomberg

The similar movement of global indexes has been mostly a boon to investors during the four-year bull market. Indexes in the U.S., Europe, and Japan reached six-year highs last month, while MSCI’s gauge of developing markets climbed to a record. This year, the average daily correlation between the MSCI World gauge tracking developed markets and MSCI’s measure of emerging markets increased to 0.87, according to Bloomberg data, which dates back to 1988 for that comparison. A correlation of 1 means stocks are in lockstep, while minus 1 indicates stocks are moving in opposite directions. A reading of zero means they’re not correlated. BNP Paribas this month arranged trades for clients to bet that price movements among the 50 largest companies in the S&P 500 will diverge from the index itself. Clients are also wagering that the volatility of an index such as the Nasdaq 100 will diverge from that of a benchmark such as the S&P 500. They also made similar bets involving the Nikkei and the FTSE 100 Index in previous months.

Individual stock picking is becoming more important for hedge-fund broker Louis Capital Markets LP. Louis Capital’s London-based Managing Partner Michael Benhamou advised clients to buy shares in Horsham, Pennsylvania- based Toll Brothers Inc., the biggest U.S. luxury homebuilder, and sell Los Angeles-based KB Home short. That’s a bet KB Home, the fifth-largest U.S. homebuilder, will suffer more from rising delinquencies in the subprime loan market. Short-selling is when investors borrow stock from a shareholder on the expectation of profiting by buying the securities later at a lower price and returning them to the holder. So far this month, Toll Brothers has lost 1.6 percent, less than the 5.4 percent drop for KB Home. Emmanuel Bague, who oversees the US$20 million Rivoli Equity Fund at Rivoli Fund Management in Paris, uses Benhamou’s recommendations. “I am just trying to make money in a market where outperformance keeps shrinking,” said Bague. Bague bought France Telecom SA shares on Feb. 28 and shorted shares of the company’s German rival Deutsche Telekom AG. Through March 22, he made about a 6 percent net gain on the investment as shares in France Telecom caught up with the German company’s performance in February.

Correlations have risen further this year even as the S&P 500 posted both its biggest daily slide and its steepest weekly rally since 2003. The Chicago Board Options Exchange’s SPX Volatility Index, which measures expected market swings, also had its biggest one-day increase ever on Feb. 27. The correlation between the MSCI World and the MSCI World Small Cap Index has increased to 0.96, the highest since at least 1995, Bloomberg data show. Stocks have increasingly traded in tandem this decade as interest rates near 0 percent in Japan and borrowing costs that fell to four-decade lows in the U.S. spurred investors to tap overseas markets in search of higher returns.

The globalization of international trade and economies, greater ease in investing oversees through exchange-traded funds and the proliferation of hedge funds pursuing similar strategies have also helped spur the increase in correlations, according to Ablin, David Joy of RiverSource Investments LLC and Darst. “What’s behind it is the global river of liquidity that’s flowing in full spate,” said Darst, who oversees US$700 billion as chief investment strategist at Morgan Stanley Global Wealth. “It’s liquidity, it’s unanimity of opinion, it’s a little bit of lack of discrimination between risky and not-so-risky assets.” The New York-based strategist said that electric utilities and trucking companies were two groups that had been less correlated to the broader market in recent weeks. Since the S&P 500 reached a six-year high on Feb. 20, a gauge of utilities added 4.1 percent, while the broader index lost 1.6 percent. The S&P 400 Trucking Index climbed 21 percent in 2007, three times the gain of the S&P 400 Midcap Index. Investors should buy shares of European drugmakers such as AstraZeneca Plc in the current environment, Darst said. London- based AstraZeneca trades at 14.2 times earnings, below a five- year average of 20.7. He also recommended cash, Treasury Inflation Protected Securities, and “real assets,” such as trees instead of timber stocks and oil wells instead of energy producers, to diversify.

“People are giving up the ghost too quickly when they don’t consider these other things,” Darst said. The relationship between certain stocks and markets may still break down, he said. An economic decline in one region may spur investors to adopt different goals, thereby breaking the correlation, said Bruno Crastes, chief investment officer of the U.K. office for Credit Agricole Asset Management. The European Central Bank raised interest rates this month for the seventh time since December 2005, pushing its key refinancing rate to 3.75 percent. The Bank of Japan doubled its benchmark rate last month, while the Fed’s rate has been at 5.25 percent since June, the highest since March 2001. “If we have less liquidity, the market will change its beat,” said Crastes, whose company manages US$94 billion. “This may be caused by higher rates, or by a relevant event such as a big default, what happened in the U.S. subprime market.”

More than 20 subprime lenders were forced to close down or sell assets since the start of 2006, and late payments on mortgages last quarter climbed to the highest in four years. That sparked concern it may drag down the broader U.S. economy and contributed to last month’s rout across global equities. “If we have a recession, it’s going to impact Japan and Europe and China,” said Joy, who helps oversee US$156 billion as chief market strategist in Minneapolis at RiverSource Investments, a unit of Ameriprise Financial Inc. “All things being equal, higher correlations are likely here to stay.”