Why we can’t trust market signals

By Felix Salmon
July 1, 2009

Tadas Viskanta does a good job of rounding up the reaction to the news that correlations are hitting new highs — this time on the way up rather than on the way down. He’s not worried, though:

It is now well documented that asset class correlations tend to one during times of economic and financial market distress. 2008 was nothing if not characterized by economic distress and financial market instability. Indeed as we exited 2008 an economic depression and the end of the global financial system were at the top of the minds of investors and political leaders alike.

In that sort of environment correlations are, and should be, an afterthought. As we exited that time of extreme fear we should see a bounce back in the prices of risky assets. So the high correlations we are seeing are a natural result of the steep fall and equally steep ascent in investor sentiment and market prices.

If Tadas is right — and he might well be — then I think there are two further implications. Firstly, anybody looking at upwardly-sloping markets and seeing “green shoots” is deluding themselves: all we’re seeing here is an artifact of the financial crisis and the market craziness associated with it.

More generally, the high correlations in the market right now do seem to indicate that we’re emphatically not out of the crisis yet. And trying to apply an implicit efficient-markets hypothesis these days — the markets are going up so there must be some good news — is ludicrous: it’s precisely at times like this, when correlations are at all-time highs, that the EMH breaks down entirely.

Most of the time I trust the markets at least a little bit, not because they’re particularly reliable, but just because they’re less unreliable than anything else. High correlations are a signal to start treating market signals with extreme prejudice. Which is one reason why I’m still so bearish.

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