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Equity Risk Monitors — December 5, 2023

Equity Risk Monitor Highlights | Week Ended December 1, 2023

  • November Factor Reversal
  • More on Diversification Ratios

November Factor Reversal

In the United States, November was one of the strongest months for equity markets in years.  The reversal to a strongly positive return in the Market Sensitivity factor from the prior month’s highly negative return is notable, as the market’s gains were spurred by increasing risk-taking.  The Volatility factor also eked out a positive return for November after crashing over the last half of the year. These two factors going positive together generally signals a “risk-on” trade, but rising risk forecasts and increasing correlations take a bit of the shine off.

The following chart is not published in the Equity Risk Monitor but is available upon request:

More on Diversification Ratios

Throughout the developed world, most of 2023 saw “diversification ratios” increase back to historically average levels (around 4.0) leading to the conclusion that the danger present throughout the 2022 period of monetary tightening and the ensuing market stress was dissipating.  The diversification ratio for an index is the difference between the weighted sum of the index constituents’ forecast total risk (equivalent to computing the index risk as if the correlation between all pairs of constituents were 1.0) and the actual index risk forecast using the appropriate regional model’s factor covariance matrix.  In other words, it is an estimate of the “diversification benefit” gained by owning an index portfolio where the constituents of that index are not perfectly correlated.   A higher diversification ratio implies a) lower index total risk, and b) greater dispersion in asset returns within a market.  Both of these properties are generally viewed as positive qualities for a market to have.

As we noted last week, we have seen a sharp reversal in diversification ratios across developed markets:

Other developed markets, such as the UK, Japan, Canada and Australia saw their diversification ratios drop much earlier in the year:

Typically, lower diversification ratios are driven by increasing pair-wise correlations within markets, and we see that to be the case with the exception of the UK over the 4th quarter thus far.

The following chart is not published in the Equity Risk Monitor but is available upon request:

So- while developed markets, particularly the US, had a very strong November, risk appears to be creeping subtly back into the picture as 2023 comes to a close.