Traders Seek Salvation From Correlation

Traders Seek Salvation From Correlation

By JOHN JANNARONE

Is stock picking a dead art?

It has looked that way in recent weeks, as macro issues such as the solvency of European countries and fears of a global economic slowdown have overshadowed fundamental differences between companies. The consequence is that stocks are moving in tandem, indicating a high degree of correlation.

CORRLEATEHERD

CORRLEATEHERD
CORRLEATEHERD

Based on one-month trailing movements, S&P 500-index stocks have a correlation of 80%, even higher than the 73% peak reached during the crisis in late 2008, says Ana Avramovic of Credit Suisse.

The impact is felt by everyone from small investors to the most sophisticated hedge-fund managers, who often go long and short different stocks rather than bet on market direction. Indeed, Ms. Avramovic points out that hedge funds tend to perform better when correlation declines and suffer when it increases. That explains the conservative tack many funds took in August, when some pushed their cash allocations to 90% or more.

The big fear for investors is that correlation will remain permanently elevated. While August’s turbulence can be blamed on specific macro issues, correlation levels have trended higher in the last few years. That suggests structural changes may have played a role.

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One potential reason is the popularity of exchange-traded funds. ETFs account for more than 30% of volume in U.S. stock markets, compared with just 2% in 2000, Credit Suisse says. It’s reasonable to expect ETF trading to drive correlation higher because many of the vehicles are tied to stock indexes.

Even so, ETFs were by no means the beginning of index-based trading. Mutual-fund managers have traded baskets of stocks tracking the S&P 500 for decades. Stock index futures began trading in 1982 and they remain far larger than ETFs. According to CME Group, the value of CME E-mini S&P 500 futures traded each day is more than four times the combined volume of SPDR S&P 500 ETF and iShares S&P 500 Index ETF.

Another trend that may have boosted correlation is the decline in structured products. Before the 2008 crisis, banks in Europe and the U.S. created and sold many billions of dollars in structured notes tied to options on single stocks, says Michael Schmanske, head of U.S. index volatility trading at Barclays Capital. The vehicles generated income by selling such options for a premium, in turn creating a larger and broader market for individual-stock options, he says. But for reasons including counterparty risk, structured products went out of favor in the crisis.

The result has been that a range of market participants, from big banks to hedge funds, have adopted more macro-oriented strategies. And even if there’s no evidence that high-frequency trading firms are a source of correlation in their own right, they are likely to reinforce it by following other participants and trading products like ETFs.

All that suggests that correlation could remain higher in coming years than before the crisis. The trouble today is that there’s no clear path to a resolution of Europe’s sovereign-debt crisis or a clean bill of health for the U.S. economy. In both cases, it could take months before investors have real visibility. In the meantime, stock pickers might want to brush up on their macro knowledge.

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