After the Market Crisis, Does Diversification Still Work? (Part 2 of 4)
Looking back before the most recent crisis, we also saw high correlations during earlier periods of stress. For example, in the prelude to the Asian crisis in 1997, the U.S. equity market had a relatively low correlation, around 0.32, with non-U.S. stocks. That correlation jumped by more than 50% as the world focused on the turmoil in Asia. A similar phenomenon occurred a year later with the Russian default in 1998.
Market Realist –
The Asian crisis saw an increase in correlations across the board.
The Asian crisis was a period of financial crisis that gripped Southeast Asia in July 1997 and raised fears of a worldwide economic meltdown due to contagion.
The Thai government was forced to float the baht due to lack of foreign currency reserves to support its fixed exchange rate, which led to the plummeting of the baht.
The graph shows the correlation between the S&P 500 Index (SPY) (IVV) and the MSCI World ex. USA Index (ACWX). It also shows the correlation between the S&P 500 and the MSCI Asia ex. Japan Index before and during the crisis, considering weekly returns.
The correlation between the United States and the rest of the world from January 1997 to July 2007 was 0.51. It increased to 0.67 during the crisis. The correlation between the S&P 500 and the Asian stocks was as low as 0.1 before the crisis. It increased to 0.55 during the crisis.
This again proves that diversification with international stocks is not as effective during crises. It also underscores the importance of adding to your portfolio safe havens like gold (IAU) and Treasuries (TLT) (IEF), which provide great protection during a crisis.
The next part of this series explains how you can use diversification as a tool, in spite of any crises.
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