A Brief History and Analysis of Equity Market Correlations vs BoomBustBlog Analysis

We performed an analysis of the correlation of the stock prices of
the companies that we have covered over the last two years to the
broader stock market. Based on the price movements in the selected
stocks and S&P 500 over the last decade, we mapped the pattern seen
in the degree of correlation that is exhibited when there are changes in
the overall market direction owing to change in the “perceived”
macro-situation.

For the purpose of our analysis, we divided the total period under
consideration (December 31, 2000 till August 31, 2010) in to four
sub-periods reflecting four different market sentiments:

• Pre-crisis- Dec 31, 2000 -Dec 31, 2007 – Long-term
• Financial crisis- Jan 01, 2008 to March 09, 2009
• Rally – March 10, 2009 to April 30, 2010
• Correction – May 01, 2010 to Present

Based on the daily prices of the stocks and S&P 500 in the
aforesaid periods, we calculated the following metrics to analyze the
degree of correlation as well the relative price movements:

• Correlation coefficient
• Beta
• Annualized volatility
• Ratio between stock volatility and S&P 500 volatility
• Annualized return
• Z-score – calculated by dividing annualized return by annualized volatility
• Ratio between stock z-score and S&P 500 z-score

Based on the matrix obtained, we have the following key observations:

• Correlation – The movements of the selected stock prices are
  becoming increasingly aligned to the broader market movements as
  reflected in the increase in the correlation coefficients of the daily
  returns of the selected stocks to the daily returns of S&P 500. The
  correlation during the financial crisis period (Jan 01, 2008 to March
  09, 2009) and the subsequent rally (March 10, 2009 to April 30, 2010)
  was substantially larger than the correlation observed in the pre-crisis
  period.  The correlation during the recent correction phase (May 01,
  2010 to present) has been even larger. One can hazard a guess that the
  primary rationale behind this increased correlation is that the selected
  stock set which primarily contain REITs and the bank stocks are the
  ones which are most influenced by the turn of events in the mortgage
  market and the overall financial system which are the heart of the
  current  economic slowdown).

• Volatility – The volatility in the daily returns of the selected
  stocks spiked substantially during the financial crisis. Comparing the
  volatility seen in the selected stocks with volatility seen in the
  broader market, it is observed that the increase in volatility in these
  stocks was multi-fold when compared with increase in the volatility in
  the broader market. The same can be easily seen in the ratio of stock
  volatility and S&P 500 volatility. The increase was particularly
  large in banks (PNC, STI, WFC, GS, MS, JPM, BBVA) and insurance (HIG,
  REITs (GGP, MAC) and monoline insurers (AGO).

The volatility moderated across the selected stock set in the
subsequent rally phase, but on a relative basis (compared to the
volatility in the overall market), the volatility in the stocks still
remained at very high levels.

The volatility during the recent correction phase has further
moderated but volatility of certain stocks including STI, HOT, FRO,
BBVA, HIG, AGO, USG and GET remain at high levels

• Beta – Beta, which measures the change in stock return per unit
  change in market return, is a function of correlation of the stock
  returns to market returns and the ratio of stock volatility to market
  volatility (Beta = Correlation coefficient  X Ratio of stock volatility
  to market volatility). Thus, this systematic risk can increase either
  due to increase in correlation (stock being more aligned to the general
  market movements) or increase in the relative volatility of the stock
  against the volatility in the broader market (due to stock specific
  issues).

Comparing across the sub-periods, it is observed that the beta of the
selected stocks was the highest during the rally phase showing that the
relative stock movement was higher when the market was rising than when
the markets were falling (during financial crisis and the recent
correction phase). On bifurcating the increase in beta into the
two components – increase in correlation and increase in ratio of stock
volatility to market volatility, it is observed that although the
correlation has been consistently increasing across most of the stocks,
the change in the ratio of stock volatility to market volatility is
behind the change in the beta during different sub-periods. Thus, it can
be concluded that although the movements in the stocks are becoming
increasingly aligned to the market movements, the change in the stock
volatility vis-à-vis market volatility is dictating the relative stocks’
performance vis-à-vis the broader market under different market
sentiments.

The relative volatility of the stock’s returns vis-à-vis broader
market under a particular market sentiment is determined by the stock
specific issues as well as the base effect (The base effect can be
explained with help of a example. For example, a stock A was trading at
$100 at the beginning of financial crisis and fell 60% during the
financial crisis phase.  The market index B was trading at 1000 at the
beginning of financial crisis and fell 30% during the financial crisis
phase.Thus, during the financial crisis, the computed beta for the stock
during financial crisis phase will be 2.0 ( i.e 60%/30%). However, if
the market recovers to the pre-financial crisis level, the stock will
have to increase by 150% and the market by 43%, implying beta of 3.5).
The base effect partly explains the high beta observed in the rally
phase (March 10, 2009 to April 30, 2010) against the beta during the
financial crisis phase (Jan 01, 2008 to March 09, 2009).

• Returns – We calculated the annualized returns of the stocks during
  the four sub periods based on the closing price at the beginning and end
  of each period and have compared the same with the annualized return of
  the S&P 500. It is observed that ratio was higher for the rally
  phase (March 10, 2009 to April 30, 2010)  than the ratio for the
  financial crisis phase (Jan 01, 2008 to March 09, 2009). The same can be
  largely a result of the base effect, explained earlier.

It is further observed that negative movement seen in the stocks in
the recent correction phase (May 01, 2010 to present) is in most cases,
multifold the decline in market decline. The same is again due to beta
> 1 which reflects a relatively larger negative impact of the change
in market sentiment on the selected stocks than the impact on market as a
whole. The stocks with highest declines during the correction phase
include USG, AGO, HIG, WFC, WFSL, FRO, PNC and STI.

• Z-score – We calculated the z-score to analyze the return per unit
  of volatility to evaluate these stocks as a potential hedge under a
  given scenario.  The ratio of the z-score of stocks to the z-score of
  S&P 500 reflects the relative performance vis-à-vis market. However,
  since these stocks are highly volatile, the z-score of these stocks in
  the downtrend (financial crisis phase) and uptrend (rally phase) are
  very low. However, during the recent correction phase, the decline per
  unit of volatility has been quite high in some stocks which are
  available in the subscriber PDF attachment here: Market Correlation Analysis (available to all paying subscribers, click here to subscriber!)

We have also looked at the banks that we have covered by parsing the
latest credit metrics from the company filings. Yes, Reggie is still
bearish on the bank, shenanigans, bailout games and all. Our findings
are interesting and I will be publishing them shortly.

Comments

[Jesse Liversore]

"Our findings are interesting and I will be publishing them shortly"

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Save virtual ink, please dont.