Chicken Little Gets it Wrong Again

Abstract

An acorn fell on Chicken Little’s head, and he concluded that the sky was falling. Stocks’ return correlations have moved toward one at times, and current day Chicken Littles have concluded that, when this happens, alpha opportunities are diminished. Both conclusions make about the same amount of sense. The Chicken Little argument, that alpha opportunities diminish in high-return correlation environments, boils down to the assertion that, if all correlations are close to one, then stocks move in unison and there is little opportunity to exploit relative returns, because they have largely disappeared. By themselves, however, correlations close to one do not imply relative-return scarcity, particularly the kind that alpha seekers try to capture.

Keywords: alpha, active management, high correlation

JEL Classification: G11