August 30, 2011

High Correlation in Stocks

While Irene splashed Wall Street, we Coloradans reveled in the ridden glory of the USA Pro Cycling Challenge. The 500-mile route hosted 130 of the world’s top cyclists including Tour de France winner Cadel Evans and both runners-up, Luxembourgers Andy and Frank Schleck.

We were there, clanging bells and hooting our hearts out. Here is winner Levi Leipheimer readying for the time trial that put him in yellow. The peloton left Avon here for Steamboat, and Levi is visible midway in yellow. At the finish, some 250,000 jammed downtown Denver for the epic, lapping conclusion. We are proud of American cycling and our state’s awesome organizational effort.

Speaking of peloton, Wall Street Journal reporter John Jannarone wrote Monday in the Heard column called “Traders Seek Salvation from Correlation” about how stocks race in formation. It’s among the best pieces we’ve seen on modern trading. Jannarone says that S&P 500 stocks show 80% correlation in the past month, meaning eight in ten move synchronously.

This is a source of distress for IR folks trying to distinguish a strong company story from the herd. We’d argue that rather than slamming the collective IR noggin into the burgeoning brick wall of macro-focus investing that you instead track program trading and establish what level is acceptable – and use it as an IR success measure. We wrote about this last week, so we won’t retrace the trodden path.

Why a mirror image across so much of the market? One driver Jannarone posits is Exchange-Traded Fund investing. According to Credit Suisse, these drive some 30% of daily stock volume. Jannarone also notes that trading in S&P 500 E-mini futures contracts is more than four times the combined daily volume of the two biggest S&P 500 ETFs, the SPDR, and iShares S&P 500 Index ETF.

It’s a reasonable hypothesis. If institutions trade ETFs and indexes, and hedge them with futures and options, and try to increase yield by leveraging assets with yet more futures or options in, say, currencies and Treasuries, stocks will correlate in models, and markets will reflect high volatility due to continual adjustments to these layers of equities and derivatives.

We see it, measuring speculative and program-driven trading for clients. These two dominating behaviors are also increasingly correlated. More money is pursing short-term “investment” horizons designed to produce returns in days.

Jannarone worries as do many investors that correlation is likely to last because of currency concerns. We agree. So IR should quantify market activity and report on it regularly to management. Otherwise, we’re bystanders. It’s better turning lemons to lemonade than sourly wondering when rational investment will return.

We suggest you hop on that bike and ride it.

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