Diversifying Risk When Oil Is On The Boil

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There is not much urgent to report today. The British have not bombed Tehran. Neither has America. Tehran appears to want some kind of contrived but sincere apology of wrongdoing from Tony Blair. It will probably get one. And meanwhile, oil is on the boil.

Back in America, the Chairman of the U.S. Federal Reserve went before Congress to tell the schmucks that inflation is still the “greater risk” to the American economy. Greater than what? Deflation? Debt? Another oil shock?

Here in the Lucky Country, Australian stocks correlated to American growth (read, most stocks) fell this morning in early trading. Did local stocks fall in sympathy with the plight of American consumers? Or was it empathy?

We were always confused by the difference between the two. An empathetic reaction to America’s consumer woes might go, “Gee America, I’m really sorry you’re so far in debt. You shouldn’t spend so much money. It sucks being broke doesn’t it?” With empathy, you understand where someone is coming from and want to help, even if you don’t really share the same emotions.

What about sympathy? “Gee America, we’re in deep trouble aren’t we. You have inflation. We have inflation. Our consumers have to borrow money just to support a comfortable lifestyle. So do yours. What a drag. And then there’s oil. It just keeps getting more expensive, doesn’t it? Along with rent, fruit, and coffee. Say, what are you doing tonight? Would you like to have a drink with me? We could meet in New Zealand. I know this quiet little place in Auckland…”

We jest with a purpose. “Stocks worldwide are moving closer in tandem than at any time in two decades, reducing opportunities for money managers and forcing investors used to buy-and-hold strategies to trade more like hedge funds,” reports a Bloomberg story. The term for assets moving up in tandem is, of course, correlation. The problem is that correlation gets in the way of diversification. When you’re driving against traffic, you don’t make yourself safer by switching lanes.

Is there a solution to this problem? It’s not a solution, but a crash, beginning in the riskiest equities at the periphery of the bull market is one sign that markets are “decoupling.” Train cars also decouple in a crash. But if you can’t move your equity holdings from one sector to another, or one continent to another, taking advantage of markets that aren’t correlated, what can you really do to diversify your equity risk as an Australian investor?

“We must fall back upon the old axiom that when all other contingencies fail, whatever remains, however improbable, must be the truth,” as Sherlock Holmes says. Cash.

With interest rates either headed up or staying up to contain inflation, it will not be possible globally, or even locally, to switch from one asset class to another and still make double digit returns year-over-year.

It would be nice to think so. But it’s also nice to think that politicians are not liars, that chocolate doesn’t make you fat, and that real estate always goes up.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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