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Correlation amongst stocks hits multi-decade high. That's actually a good thing for investors, not bad like many believe.

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July 16, 2010 – Comments (3) | RELATED TICKERS: VXX

 

I've been meaning to post a link to this great WSJ article for a couple of days now, The Herd Instinct Takes Over.  

 

In recent weeks, stocks in the Standard & Poor's 500-stock index have shown an increasing tendency to move in the same direction at the same time. Last week, those stocks' tendency to move in the same direction as the index hit an extreme not seen since October 1987, according to research by investment group Birinyi Associates in Westport, Conn.

The market's flock-like behavior is one more reflection of the growing influence of investors using broad-based strategies to buy and sell large blocks of stocks. Instead of picking individual stocks to hold over a period of time, they trade in and out of the market using broad indexes. Often, these investors use exchange-traded funds, which trade as easily as a single stock but contain many different stocks that may belong to the S&P 500, the Nasdaq 100 or another index.

Heavy trading in exchange-traded funds means more stocks are likely to move in the same direction on any given day. Analysts call that correlation, a mathematical term meaning similarity of behavior. Correlation is on the rise, to the frustration of investors who are trying to analyze stocks based on their underlying strengths and weaknesses.

"It is an indexing market and not a market for stocks. On good days everything goes up, and on bad days everything goes down. Everyone talks about baskets or sectors," says Jeffrey Yale Rubin, research director at Birinyi Associates. "It is harder for individual investors and even for mutual-fund managers to distinguish themselves by doing individual stock picks. They might get the product right and the earnings right, but the market goes down and the stock is going to go down as well." 

 

One would think that all of these wild swings in the market which often occur seemingly at random would make it a scary, terrible time to be an investor.  Here's the first line from the aforementioned WSJ article:

Stocks are trading in lock-step more than at any time since the 1987 crash, and the trend has some analysts concerned. 

Concerned?  I love it when the stock of a company that I'm interested in drops through no fault of its own. When that happens, all investors need to do is research opportunities that they find attractive, master their fear, and wait for their targeted stocks to fall to an attractive level.  Without all of this volatility, I probably would never had an opportunity to purchase several stocks that I have picked up here in CAPS and in real life.  

These swings are particularly great for dividend investors.  Just wait until a dividend-paying stock that you're interested in falls irrationally at the whim of Mr. Market and then scoop up shares with a great yield, assuming that you believe its payout is sustainable after doing research on the subject.

Deej 

3 Comments – Post Your Own

#1) On July 16, 2010 at 2:16 PM, russiangambit (29.42) wrote:

I think it simply means that most of market participants are short-timers following various models for a quick buck (investment banks and hedge funds). So, they mostly play indecies and  large liquid names, which move the rest of the market with them.

I dont' see how a market run 99.9% by robots  and traders is a good thing.

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#2) On July 17, 2010 at 12:16 AM, Momentum21 (81.79) wrote:

I think russian is correct and while the HFT activity is definitely concerning I think the trading community has broadened as well.

My knowledge is strictly anecdotal but the tipping point for me happened over the past week when a high net worth individual told me that "he doesn't know why more people don't trade options and take advantage of the 'free money' available."

Whenever one finds a "system" it usually ends in an ugly mess...but like Deej suggests, it does create opportunities...or maximizes your pain, depending on how you look at it. : )

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#3) On July 17, 2010 at 3:32 AM, walt373 (99.83) wrote:

A funny paradox created by the belief in the Efficient Market Theory...

1) EMT says the market is efficient, therefore the best strategy is to buy an index fund or ETF and save yourself the time and costs of buying and selling individual stocks.

2) As more people buy the whole index, the correlation of stocks increases, thus making the market inefficient. In theory, if every single market participant only bought an index, every stock would move in exact lockstep. This is as inefficient as it can get.

The more people who believe in EMT, the less true it becomes.

Can't understand why anyone still believes this garbage in the first place.

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