November 14, 2012

Correlation

“Why is our stock underperforming the peer group?”

Ever got that question from your CFO or CEO?

We hear it too. Speaking of questions, if you’re in Atlanta come throw them at the panel on High Frequency Trading for NIRI’s chapter breakfast, Friday Nov 16 at Maggiano’s in Buckhead. I’ll be there, and even better, so will the Nasdaq’s Jay Heller and the NYSE’s Rich Barry. We believe our story will rival this David Petraeus thing.

Just kidding. Back to the start, the answer most times lies in fine shades of difference. If program trading for funds and models in your stock is just 1% lower than the average in your peer group, spread over a month you might trail it by 10%.

The good news for IR folks, it’s not because you’re falling down on the job. It’s just math – which you might shake by targeting potential holders with shorter horizons and more aggressive trading proclivities.

Left unattended, these patterns tend to intensify. Mathematical models, identifying discrepancy, reweight allocations and the pattern reverses. It then repeats in shrinking cycles until something rattles the whole market and things reset.

Speaking of resets, high correlation, or uniform trading patterns, is a harbinger of looming group stampedes. Now, don’t worry. We don’t hear a thundering herd. We just see curious and repeating correlations.

Correlation in US stocks hit a record 88% in 1987 during the market crash. Before it happened, correlation soared to 81%, about the same level we saw in 2008 when Lehman left for the big brokerage in the sky and markets went the other direction.

Scott Barber at Thomson Reuters runs a continuous model of correlation in 24 global indexes (you’ll have to mine Datastream to see which). It’s about 65% now, well off the 85% reading in latter 2011 when the Euro nearly joined Lehman in the dust bin.

What’s curious is the tight range in correlation since the Financial Crisis. Before 2008, correlation in US equities averaged about 30% historically. In Barber’s data, from 2001-2006, it ran about 50%. Now, correlation doesn’t want to leave 70%. It’s like a red-alert level has been programmed into global markets.

A last correlative curiosity: VIX futures and options expire next week before Thanksgiving. The VIX engine is barely running. But it’s marked by an eerie repeating (correlated) pattern since 2008. The pattern matches currency interventions.

Maybe diverging from your peer group is a good thing! We’d like to see just a hint of normalcy again. It feels like it’s been years.

And doesn’t the whole market just feel, well, a bit like goose bumps on your skin? The data would support that conclusion. Neutral Sentiment abounds. Money won’t commit. We saw slight improvement in Sentiment to end last week but equities are still distended relative to the US dollar.

Sometimes the data seem like a scene from a Western movie where guys in a town square with sweat running down their faces are staring at each other, hands poised over guns, the clock ticking ominously in the background.

Hope nobody sneezes!

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