Correlation Doesn’t Equal Causation Which Is Fine Because That Was Never The Point

I talk about cross-asset correlations a ton and I’m still convinced that it is one of least well understand topics among retail money (actually, retail investors do understand it as evidenced by the prevalence of 60/40 portfolios, they just don’t know they understand it).

The problem – or at least one of the problems – seems to be that whenever some people hear “correlation”, they Marty McFly it right back to high school science class and regurgitate the old “correlation doesn’t equal causation” line and then subsequently tune out as if they’ve dropped the mic on me.

Of course when we talk about cross-asset correlations, we’re not talking about causation. Indeed, we’re not trying to prove anything at all. All we’re doing is looking at how assets move relative to each other.

Needless to say, a negative stock/bond return correlation (i.e. a positive rates/stock correlation) is a pillar of diversification. A 60/40 portfolio works precisely because stocks buffer losses when bonds sell off and vice versa. The second that correlation flips positive (i.e. stocks interpret rising yields as a risk-off signal and sell off in sympathy) you’ve got problems.

So in the spirit of keeping this exceptionally important conversation alive until the next VaR shock hits (which is precisely when I will get to say “I f*cking told you so”), here are some charts from Goldman that illustrate what I’m talking about.

Via Goldman 


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