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Do All Financial Assets Fall In a Market Crash? Why All Assets Correlatively Fall In a Market Crash?

correlated asset price crash, correlated markets crash, why markets crash together
A view of Bloomberg terminal during an adverse scenario

©Risk Concern. All Rights Reserved. Diversification, one of the most important tools for reducing portfolio risk, while maintaining returns, is utilized as a critical method for reducing risk exposures. Nonetheless, diversification as a risk reduction method has limitations; besides, it is a method to reduce risks, and that, of course, means that it doesn't eliminate downside risk.

In a market (flash)crash, prices have been known to decline precipitously, all at once, even for assets considered 'safe-haven,' i.e., assets that are assumed to function as 'portfolio protectors against crashes,' if you will, that wouldn't decline when, say, the stock market falls rapidly.

In the 2020 and 2008 crisis period, for example, when the equity market in the US declined, we saw a rapid decline in other assets as well:

correlated market crashes

As we can see in the graph above (highlighted in grey are the recessionary periods), when the US equity market crashed in 2001, 2008, & 2020 period (Blue Line), global commodities (red line) & Nikkei 225 index (green line) which are often included in diversified portfolios for risk diversification, also tanked.

Furthermore, as we can see in the table below, global equities, which are usually included in portfolios for diversification, also had negative returns during the 2007-09 distress period:

returns to global equity indices
Adopted from: CFA Institute (2021). Printed material; ISBN 978-1-950157-46-4

Thus, we can conclude that yes, all assets have a tendency to decline precipitously in a market crash.

However, we must also understand that this behavior, most notably observed in the last three adverse events, cannot be considered a hard rule, i.e., expected to always occur.

For portfolio/position protection, nevertheless, it is important to note that a combined crash is likely to occur, as per previous events.

Why do all assets fall in a market crash?

It is a question that is often discussed: why does the correlation of traded assets increases in a sharp market decline?

On the face of it, this observed phenomenon defies the market norms. For example, during the economic distress period of Q1 2020, gold (XAUUSD), which is considered a safe-haven asset, also declined as the equities market declined and rose as the equities markets rose (as seen in the grey area):

Gold and S&P 500 crash 2020

As per conventional thinking, gold should have held its value or risen as a safe haven asset, providing capital protection during the distress period. This, of course, wasn't the case, and an overall decline across asset classes was observed.

While analysts and academics have proposed many complex relationships, the principle of Occam's razor is applied in this report for understanding this phenomenon.

In a crisis condition, there is a prevalence and increase in the panic and fear in the markets overall.

Put simply, there is a sudden sharp rise in uncertainty; this may be caused by an adverse event, as was the case during the 2020 crisis period, or a broader emergent realization in market participants regarding the condition of the overall economy, i.e., the likelihood of an imminent recession seen as high.

The larger the relative size of the core economy where this occurs, the more probable a global contagion is; thus, the US, Chinese, Japanese, British & German economies should be of core focus.

Why correlated crashes occur

The fundamental reason that stands out as the most probable, and perhaps an axiomatic one for explaining this condition, is a sudden move by market participants into cash and out of financial assets. This is because uncertainty is perceived negatively by market participants and generally seen as unfavorable for financial assets, i.e., during times of high uncertainty, asset volatility (risk) rises, and thus, the likelihood of a sharp downward move rises as well.

Institutional investors and portfolio managers use value at risk and other quantitative models to evaluate their financial positions' risks. Most quantitative risk assessment models are based on the volatility of the subject asset, and therefore, as it sharply increases, as in the above-described conditions, risk exposure of investments increases.

During times of high uncertainty, volatility of all assets, even those labeled 'safe-haven' by analysts, rises.

To reduce this exposure, generally, institutions and other investment managers, etcetera, close their open positions/allocations, favoring cash above other opportunities; that is, till the uncertainty/high volatility period ends, after which there is again a high demand for index funds, ETFs, shares, bonds, etcetera.

Thus, all in all, high volatility, driven by high uncertainty, causes participants to move into cash till such risks dissipate. This creates downward pressure on prices of assets across the board, and a highly correlated crash occurs.

Some may argue that all managers/investors don't close open positions in the above described periods, as some use other methods such as protective puts, derivatives, etcetera, to navigate uncertainty. This is indeed accurate; however, in such times, when demand for the aforementioned instruments increases considerably, it also puts downward pressure on prices in the market.

For example, when the demand for protective puts increases considerably, and option issuers write a significant amount of puts, they sell the underlying assets as well to reduce risk exposures; similarly, considerable short-selling interest for portfolio hedging in the futures markets also puts downward pressure on prices.

Therefore, in times of high uncertainty, whether the protective tactic deployed is a move in cash, acquiring protective puts, or selling derivative contracts, all instruments/assets face downward pressures as described above, increasing the inter-asset correlation.

A hypothetical example for further clarification:

A fund manager manages a $1 billion portfolio and uses statistical methods in conjunction with scenario simulating techniques and VaR to gauge the total risk exposure per 1-month window. She has a mandate to ensure that probable losses don't rise above 20% of the portfolio value.

Let's assume that due to the default of a large financial institution in the US & the co-dependencies amongst other major institutions, the overall uncertainty and volatility in the markets rise sharply. Her risk models signal probable losses over 25% in all open positions, including precious metals.

(closure of positions as a certain VaR level is exceeded, is an automated process at times)

She closes all positions with the intention to re-enter the markets when the conditions become more favorable as per her models.

As the uncertainty rises, others, including retail investors, etcetera, may also close their open positions to stay protected against losses.

All assets are likely to see a sharp downward price readjustment in such a condition, as observed during the 2008 and 2020 crisis period.

A further caveat

It is also important to note, nonetheless, that concerns regarding the USD's value retention capacity are now coming to the forefront; concerns, arguably, have been given air by quantitative easing (QE) methods deployed by the Federal Reserve in the last two periods of financial distress. QE has raised serious concerns regarding the USD's value retention capacity; indeed, some have described QE as monetary shenanigans.

Through an alternative prism of view, we can see QE as a deterrent for investment managers, etcetera, disadvantaging a liquidation, as investors may develop a secondary concern regarding liquidation, i.e., the loss of purchasing power of the currency during the period of liquidity.

Lastly, as most periods of economic distress don't emit leading conformational signals of their occurrence, we are still likely to see a sudden move into cash during the next such period, despite concerns of deterioration in the purchasing power of the USD.

This is because other methods of eliminating exposure to volatility, such as protective puts, derivatives, etcetera, can be expensive during the time of high volatility, and even such tools, as described above, can create flash crashes. Closing open positions temporarily, nevertheless, is still likely to be the favored method in future adverse events, and therefore, we are likely to see correlated asset crashes in the future as well.

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