Correlation is a statistical measure of the degree to which investment returns move together. Between 1991 and 1994, the correlation between the S&P 500 index and high-yield bonds was low, at 0.2 or 0.3, according to Pimco statistics. (A correlation of 1 means returns move in perfect sync.) International stocks had a correlation with the S&P 500 of 0.3 or 0.4, and real-estate investment trusts had a correlation of 0.3, according to Pimco data. Commodities showed little correlation to U.S. stocks. By early 2008, investment categories of just about every stripe were moving significantly more in sync with the S&P 500. The correlation on international stocks and high-yield bonds rose to 0.7 or 0.8, and real-estate investment trusts to 0.6 or 0.7, according to Pimco's data for the previous three yearsRead the whole thing here (note: subscription required).
The problem with portfolio diversification is that it is typically implemented using historical correlations (actually, on covariances, but the two are essentially the same). To provide optimal diversification, portfolio allocations should be made based on "forward looking" correlations. In practice, some managers adjust historical correlation estimates to reflect their views of future relationships. But that becomes far more complicated than simply using historical estimates and assuming that they'll continue unto the future.
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