If there is one thing you can count on, it is market volatility. A bit of bad news, and every index seems to drop. Historically, stocks have collectively recovered and gone on to reach new highs. Sometimes that happens within a matter of weeks or months. Other times, it takes years.
For some investors, the lean periods decimate portfolios, because they can’t hold out until they make up their losses. They lose a fortune when the market falls, and they never regain their principal. However, it’s not a foregone conclusion that individual portfolios will follow larger market conditions. There is a way to protect your portfolio through a carefully considered strategy.
Some investors have structured their holdings to maintain steady returns through market highs and lows. They have mastered the art and science of choosing stocks that are negatively correlated. When one group goes down, the other goes up – and vice versa. Instead of a roller coaster, they enjoy a gentle rise regardless of what the market is doing.
Stocks that consistently move in opposite directions are considered “negatively correlated”. The relationship may also be referred to as “inversely correlated” This doesn’t happen by chance. The factors that work to drive one group of stocks up simultaneously have a negative effect on another group of stocks, so the two sets can be relied upon to move concurrently.
That brings up a critical question for investors interested in protecting their portfolios: what stocks are negatively correlated?
What Is Perfect Negative Correlation?
In most cases, the negative correlation between stocks is inexact. For example, the factors causing a decrease for one group might drive share prices down by 25 percent, while negatively correlated stocks only increase by 5 percent. The exact relationship between stocks is expressed on a scale from -1.0 to 1.0.
When two stocks increase together and decrease together at the exact same rate, they have a perfect positive correlation or a correlation of 1.0. For example, when ABC stock increases by 5 percent, XYZ does the same.
On the opposite end of the spectrum, two stocks that move at the same rate in opposite directions have a perfect negative correlation or a correlation of -1.0. When ABC stock increases by 5 percent, XYZ stock decreases by 5 percent.
Few stocks have perfect correlation, whether positive or negative. In the vast majority of cases, correlation falls somewhere between -1.0 and 1.0. As a general rule, a negative correlation between -1.0 and -0.70 is considered quite strong, and anything between -0.30 and 0 is weak. The middle range indicates two stocks have a moderate negative correlation.
What Industries Are Negatively Correlated?
Some industries can be relied upon to move in opposite directions. For example, a number of industries are heavily dependent on oil prices and related stocks. Airlines, trucking companies, and aerospace companies all respond poorly when the price of oil increases. When the price of fuel goes down, these stocks go up.
There is also a strong negative correlation between the financial industry and industries that increase their profits when interest rates go down.
Examples include utilities and companies involved in real estate. When interest rates go up, these stocks go down. Meanwhile, financial services companies see increases in their stock when interest rates go up.
What Is An Example Of Negative Correlation?
Stocks aren’t the only assets to consider if you want to structure your portfolio with an eye on mitigating risk through negative correlation. In many cases, other asset classes move in the opposite direction of the stock market.
For example, gold gets a lot of attention when dips in the stock market are expected. It is widely regarded as a safer investment, and demand goes up – along with gold prices – when investors get spooked by market conditions.
Gold is also known to have a negative correlation with the value of the US dollar. As the value of the dollar goes down, gold prices often go up, making gold a popular choice to reduce inflation risk.
Some argue gold is more of a safe haven when confidence in governments falls as opposed to being an inflation hedge.
Are Stocks And Bonds Negatively Correlated?
Nearly every investment advisor recommends a blend of stocks and bonds to keep a portfolio balanced. That’s because bonds add stability, while stocks tend to generate higher returns.
Stocks and bonds are also thought to have a negative correlation for reasons quite similar to the relationship between stocks and gold. Conventionally, bonds are considered far less risky than stocks, so demand rises when the stock market is particularly volatile. Investors sell stocks, causing share prices to drop, and they increase their bids on bonds.
However, the presumed negative correlation between stocks and bonds isn’t quite as straightforward as this logic would seem to indicate. While historically there has been a negative correlation during periods of economic uncertainty, the rest of the time, the correlation has been positive.
What Is Negatively Correlated to S&P 500?
The best way to protect against downturns in the S&P 500 is to include gold and bonds in your larger portfolio. Both have demonstrated that they hold their value when the S&P 500 drops, and in some cases, you will see returns.
If you don’t mind taking on some risk and you are confident the S&P is on the verge of decline, you may wish to consider an inverse ETF. The goal of these products is to generate returns when the market is trending into negative territory.
Examples include ProShares Short Russell2000 (RWM), ProShares Short Dow30 (DOG), and AdvisorShares Ranger Equity Bear ETF (HDGE).
What Stocks Are Negatively Correlated? The Bottom Line
Many financial services professionals spend their entire careers studying correlation between various assets. The most reliable negative correlations occur when the factors that cause one stock to go up have the opposite effect on the other stock. However, it is important to note that correlations can be cyclical, or they can change over time.
It is also possible that stocks which appear to be negatively correlated aren’t actually connected. In these cases, the inverse movement is a mere coincidence. In such situations, you will notice the apparent negative correlation begin to fade fairly quickly.
As you work to create a portfolio that can withstand market ups and downs, understanding what stocks are negatively correlated today is important. It is just as important to reevaluate and update your portfolio regularly to account for changes in the strength of a negative correlation.
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