Since early October we’ve seen sterling rise against the US dollar and the FTSE 100 gain a little. This should remind us of the truth and importance of a saying popularised by George Mason University’s Scott Sumner: “never reason from a price change”.
The thing is that this combination of rises in both sterling and Footsie is a recent one. A few months ago we often saw the two move in opposite directions. For example, last winter the index fell as sterling rose while earlier this year it rose as the pound fell.
The link between sterling and equities is, therefore, unreliable. Sometimes, a fall in the pound raises share prices because it increases the sterling value of overseas earnings. At other times, though, the two move in the same direction. This can be because optimism about the UK economy might raise both while pessimism would reduce both. Or it could be because investors’ appetite for risk changes; because sterling and equities are both risky assets a greater appetite for risk raises both share prices and the pound while lower appetite weakens both.
Hence the wisdom of Professor Sumner. If we want to know how a change in one price (say of the pound) affects something else (say shares) we must know why the price changed. A rise in sterling caused by (say) increased appetite for risk would often be associated with shares rising. But one caused by expectations of tighter monetary policy would not be, unless those expectations are the result of a stronger economy.
The point broadens. A rise in oil prices, for example, caused by increased global demand might well see shares rise. But one caused by a drop in supply could see them fall.
Or take gilt yields. A fall in these caused by fears about the global economy or by increased risk aversion would see shares fall. But a fall caused by hopes of lower interest rates, unaccompanied by economic fears, might see them rise.
Or take the question: how would house prices respond to higher interest rates? The answer is badly, if rates rise because the Bank of England decides to take a tougher stance against inflation. But if rising rates are a response to rising incomes, house prices could also rise as rates rise.
All this explains the pattern in my chart. It shows that correlations are unstable. In the mid-1990s, for example, falls in gilt yields were strongly associated with rises in share prices. But in the 2000s they were accompanied by falls in them. And while falls in sterling were mildly associated with rises in equities in the 1990s and early 2000s they were associated with falls between 2007 and 2017. And recently both correlations have been close to zero, with falls in gilt yields or in sterling both being about as likely as not to see shares rise as fall.
This corroborates an important point made by the political scientist Jon Elster. In the social sciences (and investing is merely applied social science) we can sometimes explain without being able to predict and vice versa. After the fact, we might be able to explain Footsie’s reaction to a fall in the pound because we know (or at least have an idea) why the pound fell. But before the fact, we cannot predict how Footsie would respond because we cannot know for sure in advance why sterling would fall.
For investors, all this matters. It means we cannot rely on historic correlations alone as a guide to risk management. This mistake can be an expensive one, made even by experts. In 1998 the hedge fund Long-Term Capital Management, whose partners included two Nobel prize-winners, collapsed when bets they thought were uncorrelated suddenly lost money at the same time.
You might think that bonds are good insurance against falls in equities. And you’d be right, if shares fall because of fears of recession or reduced appetite for risk. But if investors fear that central banks will tighten monetary policy then we could see losses on bonds at the same time as shares fall – as we saw, for example, during the taper tantrum of 2013.
Or take foreign currency. This too can be insurance against falls in equities, because sterling often falls when investors get more nervous. But this link isn’t reliable. If a rise in sterling sees shares fall because of expectations of lower future overseas earnings, we would lose on both UK equities and foreign currency.
Luckily, there is a simple, if dull, solution to this – to hold cash. Yes, its returns are nugatory. But it has the virtue of protecting us from correlation risk – the danger that negatively correlated assets will suddenly become positively correlated and so lose us money at the same time. This danger is unquantifiable, but that does not mean it is insignificant.
