The "Correlation with Averages including Recession Periods" indicator is designed to measure the correlation between a user-selected base asset (e.g., the S&P 500) and another financial asset across different time frames. Additionally, it provides a specialized feature that calculates correlation specifically during recession periods, using data from the FRED
indicator, which identifies U.S. recessions. When the value of FRED:USREC is greater than 1, the script marks that period as a recession and highlights it with a white background on the chart.
The indicator offers:
Correlation over Multiple Time Frames: It measures the correlation between the chosen asset and a base asset over several distinct time periods: 1 week, 1 month, 1 year, and 5 years.
Recession-Specific Correlation: An additional column in the displayed table shows how the correlation behaves specifically during recession periods. This allows investors to see whether correlations between assets change under economic stress conditions.
The Importance of Correlation in Portfolio Management
Correlation is a statistical measure that expresses how two assets move in relation to each other. In portfolio management, understanding correlations is crucial because it helps in the construction of a diversified portfolio, which can mitigate risk while maximizing returns. According to modern portfolio theory (MPT) introduced by Harry Markowitz (1952), assets with lower correlations to each other tend to create more efficient portfolios by reducing overall portfolio risk without sacrificing returns. When assets are less correlated, the chances of simultaneous losses across all portfolio components are minimized.
During recessions or economic downturns, correlations between assets can shift dramatically. For instance, correlations between stocks may rise, as nearly all assets become more aligned due to systemic shocks in the market (Longin & Solnik, 2001). This phenomenon—referred to as "correlation breakdown" during extreme market conditions—can undermine diversification strategies if not accounted for. Therefore, it becomes imperative to monitor correlations during both normal and recessionary periods.
Academic Perspective on Correlation:
Campbell, Koedijk, and Kofman (2002) found that during volatile markets, particularly during economic downturns, correlations between global equities tend to increase, making it harder for international diversification to provide the same risk reduction as in normal periods.
Engle (2002) introduced the DCC-GARCH model, which allows for the dynamic measurement of correlation changes over time, reinforcing the idea that asset correlations are not static and evolve under different economic environments.
How Users Can Optimize Their Portfolios Using This Indicator
Investors can use this indicator to improve portfolio optimization in several ways:
Assessing Asset Correlation Across Time Frames: By evaluating correlations across different time frames (1 week, 1 month, 1 year, 5 years), users can understand the consistency or variability of an asset's correlation with a base asset (e.g., the S&P 500). This helps in determining whether the asset can contribute to portfolio diversification over the short term or long term.
Understanding Correlation During Recessions: The recession-specific correlation feature allows users to analyze how assets behave under economic stress. If an asset shows low correlation during a recession, it may serve as a good hedge or defensive asset. Conversely, assets with high correlations during recessions may not provide as much risk reduction as expected when they are needed most.
Dynamic Risk Management: By monitoring the correlations dynamically, including during recessions, users can adjust their portfolios more responsively. For example, if correlations between risky assets like equities increase during a recession, investors might consider shifting into less correlated asset classes (e.g., bonds or commodities) to maintain diversification.
Strategic Asset Allocation: This indicator helps users in strategic asset allocation by identifying assets that maintain low correlations across various market conditions. Over time, assets with low or negative correlations with the rest of the portfolio can reduce risk without sacrificing potential returns.
Conclusion
By incorporating both normal market conditions and recession periods, the "Correlation with Averages including Recession Periods" indicator provides a nuanced tool for investors looking to optimize their portfolios. With the insights provided by this indicator, users can better navigate periods of market stress, adjust their portfolio allocations dynamically, and achieve better risk-adjusted returns.
References:
Markowitz, H. (1952). Portfolio selection. The Journal of Finance, 7(1), 77–91.
Longin, F., & Solnik, B. (2001). Extreme correlation of international equity markets. The Journal of Finance, 56(2), 649–676.
Campbell, R., Koedijk, K., & Kofman, P. (2002). Increased correlation in bear markets. Financial Analysts Journal, 58(1), 87–94.
Engle, R. (2002). Dynamic conditional correlation: A simple class of multivariate GARCH models. Journal of Business & Economic Statistics, 20(3), 339-350.