The Herd Instinct Takes Over-Component Stocks' Correlation to S&P 500...

Discussion in 'Trading' started by ASusilovic, Jul 27, 2010.

  1. Component Stocks' Correlation to S&P 500 at Highest Level Since '87 Crash

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

    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."

    Every day, Birinyi measures the 50-day average correlation between the direction of the S&P 500 and that of its member stocks. In this case, correlation is a measure of the degree to which one stock tracks the movement of the index. A correlation of 50% means half the index's component stocks are moving in the same direction as the index. A perfect correlation would be 100%, with all stocks tracking the index. The average correlation since 1980 has been 44%. This particular methodology doesn't allow for a negative correlation or a correlation of zero, since at least some component stocks must move in the same direction as the index. Some stocks almost always move in a different direction than the index. The average of their moves, usually weighted for each stock's total market value, equals the index's return.

    Earlier this year, when stocks were on the mend and investors were less anxious, the correlation between the S&P 500 and its stocks fell below 50%, suggesting investors were looking for individual stocks to own rather than just buying large indexes.

    But by mid-June, the correlation had jumped back above 70%, as investors stopped looking for winners and just sold broadly. Last week it surpassed its 2008 high of 79% and hit 81%, the highest level since the 1987 crash, when it touched 83% for one day. That means that on most days recently, the great majority of stocks in the S&P 500 were moving in the same direction, up or down.

    Correlation typically goes up during volatile periods, reflecting investors' tendency to dump stocks wholesale rather than try to pick out stocks that once were viewed as refuges, such as those that pay dividends.

    Many money managers have been moving to entirely different asset classes, such as bonds or cash, says Jack Ablin, chief investment officer at Harris Private Bank, which oversees $57 billion in Chicago. Early last month, his firm shifted hundreds of millions of dollars out of stocks and other risky assets, such as commodities, and into Treasurys and high-grade corporate bonds. "We have cut back on stocks altogether," Mr. Ablin says. In a typical customer account that might normally have 55% of its money in risky assets such as stocks and 45% in bonds, Mr. Ablin has flipped the ratio. Stocks have gone to 45%, the lowest allowed under Harris's guidelines, and bonds have risen to 55%. "The easiest thing for us to do is lower our risk" rather than try to pick and choose among stocks, Mr. Ablin explains. "I think we are going to stay with a higher bond allocation than usual for a while. We just think that the market warrants a higher degree of vigilance."

    The tendency of stocks to rise and fall together may help explain why some conservative, dividend-paying stocks have been turning in disappointing results lately, while some riskier stocks, such as computer-chip makers, are holding up better than expected.

    "One of the strategies we run is very defensive and it has not done well in May and June of this year," says Janna Sampson, co-chief investment officer at OakBrook Investments, which oversees $2.1 billion in Lisle, Ill.

    Dividend payers in the S&P 500 are down about 11% since that index's April 23 peak—about the same decline as stocks that don't pay dividends, according to research done for The Wall Street Journal by Birinyi Associates. None of the S&P 500's 10 sectors, even the most defensive, shows a gain since the April peak.

    Among the few investments showing gains since April 23 are Treasury bonds, investment-grade corporate bonds and gold.

    "Stocks aren't moving because of the sector they are in, but because the overall market is down" since late April, Mr. Rubin says.

    Exchange-traded funds, high-tech trading strategies and quick shifts to cash permit investors to react quickly to market moves without analyzing individual stocks, but they also mean professional investors have less need to use traditional defensive stocks as havens.

    Ms. Sampson of OakBrook has been especially surprised at the weak performance of stocks like Microsoft, which hasn't been behaving as the big, solid, dividend-paying blue-chip to which many investors normally would turn. Since April, Microsoft has fallen harder than the overall market. Its stock price, as a multiple of its earnings, has been below that of the broad market, something that has rarely been the case in Microsoft's history. Microsoft, of course, has suffered recently from adverse comparisons with Apple, and its status as a blue-chip hasn't offset that.

    Another problem for dividend payers is that the group includes some of the market's most volatile stocks, such as financial and industrial shares. Dividend payers in more stable groups, including telecommunications and utility stocks, have held up better, but those groups still are down.

    Some analysts believe stock prices could remain sluggish for some time. In that case, they say, investors should buy dividend-paying stocks in hopes that dividends will enhance weak price performance. So far, however, investors don't seem to be heeding that advice much.
  2. Tsing Tao

    Tsing Tao

    this is likely because the only real buyers of stocks are algos, and when they buy, they buy across the market in blocks - or ETFs, dont they?

    therefore, you would expect everything to go up, or everything to go down.

    the market is fucked.
  3. Lao Tzu

    Lao Tzu

    No offense indented.

    You posts inform.

    But derfinition stupid.

    Stock move same direction index or not?


    Little move same as big move.

    Stock move this percent, index move that percent.

    Correlate that mean something.

    Then smooth 50 day?

    Have work hard be that stupid.

    They think client stupid.

    Client believe any thing.
  4. Jimmy-Lee Billy-Bob, is that you? That two weeks in detox was a waste of money, huh?
  6. Suss, it's the "Summer of 2008" all over again! :eek: :D
  7. This is a major, major element of the current landscape. The current market is a pure factor game. What all these articles don't mention is that correlation is at all time highs in a low-volatility environment.
  8. Good article.

    in fact high correlation started since last year and has never really gone down, even in the small cap space,spready stocks show incredibly high correlation with the market, they are not "doing their own thing" anymore like they used to
  9. noticing less of this recently

    You are posting too soon after your last post. Try again in 2020
    ET wasting my time with the bullshit 2 minute posting lag
  10. its what happens when you have policies run by morons.
    #10     Jul 27, 2010