This article makes an excellent point: there will sometimes be temporary periods of high correlation between stocks when investor fears trump fundamentals. But the key word is temporary. Fear always fades and investors will return once again to fundamentals, thus making the case for diversification.
Stock price movements have become highly correlated, with correlations reaching levels not seen since 2008. This is not surprising given historical data and should end up being a temporary occurrence. … Over the long-term different types of stocks have varying correlations. Small-cap stocks, for instance, have a long-term correlation of 0.72 with large-cap stocks, according to the Ibbotson SBBI 2011 Classic Yearbook. This means that while small-cap stocks have similar returns to their bigger brethren, they do not always move in the same direction or experience the same magnitude of change. Thus, you get some diversification benefits by combining small- and large-cap stocks in a portfolio…
Read the full article at Seeking Alpha.