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Guest Post: "As Implied Correlations Approach 100%, Energy = Healthcare = Technology = A Rat’s Ass, Etc. "
From John Lohman
A hedge fund manager/friend of mine recently described forces driving the market as “barely manned scrip cannons.” Unfortunately, I believe it’s a fairly accurate description of the HFT-ETF-Algo driven cluster that used to be a market for financial assets. Individual investors have lost confidence, voted with their feet, and left us with a single asset. It comes with a put option underwritten by the federal government and its value fluctuates in response to barely manned scrip cannons.
For perspective on how this is impacting macro markets, consider the chart below. It plots the average one year rolling correlation of various markets with the S&P 500 Index. In short, a currency = a yield = a commodity index = a unicorn, etc. Completely different assets with completely different cash flow streams and terminal values are apparently fungible.
This phenomenon can also be seen within the equity market. Zero Hedge has pointed out the absurdity of the level of implied correlations several times. This chart from Barclays provides some context. As shown, the trailing one month cross-sectional correlation for the largest 1,000 stocks averaged roughly 20% for the last half of the 20th century. The remaining variance in prices would be explained by the fundamental factors within each sector, industry, and firm.
But in today’s environment, idiosyncratic risk doesn’t exist. As implied correlations asymptotically approach 100%, energy = healthcare = technology = a rat’s ass, etc.
This is the unfortunate result of markets where governments and central banks try to truncate risk and algos determine marginal prices based on short-term patterns. In the real economy, price signals have become distorted, thus causing capital to be inefficiently allocated. In the financial economy, the environment has become riskier than ever. The farther prices are pushed away from their true underlying value, the greater the adjustment will be. And one thing the algos don’t do - adjust slowly.
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'Tired and emotional' is the phrase usually used to account for such a performance. Can't wait to see their non UN diplomats.
...jet-lagged....
...and the next morning..."I aid what??????"
That's nothing. Watch this.
http://news.yahoo.com/s/ap/20100910/ap_on_el_st_lo/us_fired_up_politician
I posted same clip earlier, and was given sh*t from the redneck GOP mob on this site, who thought I was having a pop at them. No sense of humour, some people. Its still funny ;-)
Agreed. I just watched it again. Reminds me of a fat blowhard boss I had once, trying to "pump up" the sales force, but he looked and sounded more like this guy. Too funny. Sad, actually.
Wow. He did say "drastic times call for drastic measures..."
not an--new speak for "we've gotta raise the bar!!!."
hope you're doing well.
- Ned
good, thanks. and you?
@Dismal
Tin soldiers and Nixon coming,
We're finally on our own.
This summer I hear the drumming,
Four dead in Ohio.
Gotta get down to it
Soldiers are cutting us down
Should have been done long ago.
What if you knew her
And found her dead on the ground
How can you run when you know?
Gotta get down to it
Soldiers are cutting us down
Should have been done long ago.
What if you knew her
And found her dead on the ground
How can you run when you know?
Tin soldiers and Nixon coming,
We're finally on our own.
This summer I hear the drumming,
Four dead in Ohio.
Neal Young, great song.
obozo is that U, cheeky? with a hammer sickle symbol on your fore h e a d ?
"OT
China's UN diplomat in drunken rant against Americans"
Well, at least he has a history of being honest, albeit with a few drinks.
good read, juicy.
It takes a Potemkin Village
plus ça change, plus c'est la même chose
Wall Street, the MIC etc etc
http://select.nytimes.com/2005/12/11/opinion/11rich.html?_r=1
Amanda has been looking extra juicy lately.
she is very pretty, a goddess of something 4sure.
hey, ROe Boat, thanks for the reminder
Italian GP F1 tomorrow morning.
italian grand prix san marino, bitchez.
Melissa Lee wins the award this week for "Chicken Wings" arms....
OT: was listening to Drury in the background.
Why is it "bullish" that wholesale inventories rise? Especially faster then sales, taking the inventory to sales ratio higher by a tick?
Shouldn't it be more bullish if inventories go down, meaning more future inventories to make?
nice speed commercials, though. wind tunnel training.
correlation---tell me the future of aud/jpy and i will tell you the future of the universe
Welfare, bitchez!
Welfare, bitchez!
Sorry, we on it are slow. Now, where'd I put that cell phone bill?
This is some really scary shit. Seeing everything we know becoming one lie after another and having no control over anything. "They" have reached a point where everything is spiraling out of control. Nothing can be fixed and they know it, so extend and pretend all the way to the ede of the cliff and then over it.
And now another installment of 'You Know It's A Damn Fine Idea If...'
In this world of bailouts and wipeouts, CEO louts and banker pouts, we need heuristics to separate real solutions from the background noise of vociferous, competing interests. So how do you know when an idea is a damn fine idea? Here's Damn Fine Idea Heuristic #49876:
You know it's a damn fine idea if the American Banker's Association thinks it's a damn terrible idea.
http://www.cnbc.com/id/39102973
...ditto the ABA, AMA,
Good heuristic FischerB!
Here's mine: Actual good things are self-evident. For example--gold, boobs, strawberry ice cream. The more someone tries to convince you it's good, the worse it really is for you. ie war, stocks, facebook.
Good things don't need marketing, PR, & relentless propaganda.
Cheers,
Beef
I clearly have a lot to learn...
Global Empire and the International Banking Cartel
http://csper.wordpress.com/
PIL - Order of Death
'This is what you want. This is what you get.'
http://www.youtube.com/watch?v=VEC5GFDbgl4
This is why the Deflationist are DEAD STINKING WRONG!
in Detroit, although housing prices remain at all time lows, prices for Consumer goods have not gone down.
A price of a CAR in Detroit is the same as the price in Texas. Same with food. Same with energy. Same for baseball tickets. Same for clothing. (you know the drill)
Where are these lower prices?
If the price of Beer was 6 dollars for 24 cans, I would flood into Detroit back up the CAR, load up and then sell them (off the GRID) to college students and make a killing!
Great business plan. To bad there is ZERO DEFLATION in sight!
It looks like the Austrian school was correct and the definition of Inflation will need to be scrubbed from millions of textbooks worldwide
I dunno about tech stocks being correlated with the markets. At least this week, semiconductor stock most definitely did not follow the other parts if the market. They sunk like rocks.
Next week? Who knows.
FIVE HFT FINGERS
http://williambanzai7.blogspot.com/2010/09/five-hft-fingers.html
good
Doesn't anybody else think the growth of index-linked ETF's, futures and options has a lot to do with this?
When somebody buys or sells the whole index, then the whole index moves together. If you are investing through index-linked ETFs, futures and options, you are investing as if the differences between the stocks in the index don't matter. And of course I can understand why in a lot of short-term trades they don't. But taken as a whole that kind of investing is inherently stupid money, or maybe don't-give-a-rat's-ass money.
The consequence is going to be more volatility. The more people own rat's ass through ETFs vs direct, the longer the price of rat's ass is going to ignore fundamentals, until it doesn't, ie, until the stock-picking portion of the market attacks rat's ass and the ETFs et al are forced to join in.
yep, easy, liquid, no-brainer, "creation units," almost Bogel ltb&h.
'cept the last is not.
- Ned
True, if everybody buys the index, then the index would move in lock step. And, I agree with your other assertions on "dumb" and "don't care" money, and the ultimate trend towards increasing volatility (e.g., increasing correlation).
However, IMHO, this is a "devil-in-the-details" problem where we must infer the *real* shift that is occurring:
In order for what you assert to be true (and again, I agree with your observations and long-term trend), we must have:
IMHO, there is no more fundamental analysis -- that takes too much time, is too costly, and nothing makes sense anyway, so fundamental analysis has no value whatsoever (nothing is worth its current price). The financial industry is behaving like dumb/retail because they merely take the (free) Fed money, and lever-it-up in the markets (both bonds and stock futures, which is why they both move in lock step). Further, the Fed is buying both, because we have an imminent bond market dislocation (those bondholders will not be paid back -- just look at the Municipal nightmare), and we have an imminent stock market crash (future dividends are the only reason to justify the value of any stock price, and those future dividends are impossible at the current stock prices).
IMHO, the only way the DOW stays above 10K is in the case we really *do* go from "here" to hyperinflation (I give that a 30% probability).
In the "olden days", something like the Magellan Fund would perform fundamental analysis and shift capital (investment) to GE or IBM or large/mid-cap companies for productive efforts. That doesn't happen anymore -- now, the industry is in-and-out quick (and I'm not even talking HFT -- that makes it worse). So, rather than allocating capital to productive efforts, the financial industry literally allocates capital *away* from productive efforts, and rather pushes capital to momentum trades -- commodities, currency arbitrage, splash-in-the-pan IPhone releases, etc. Even banks day-trade your demand deposit accounts (checking accounts) through nightly sweeps (wow). Now, the financial sector is literally random splashes in an over-full bucket of water that is being kicked in every direction with random market noise (seasonal cycles, government program announcements, populist moods on light bulbs, etc.) Literally, *everything* is now "dumb money".
(The only exception to "dumb money" is "Friends of the Fed" money that can front-run the taxpayer, the dumbest money of them all.)
IMHO, the volatility is because the financial sector makes no sense: Nothing is worth the price, and everyone is thrashing (there is no place to put your money, so index/market/sector movement is volatile because it is random).
I wouldnt call buying index linked ETFs dumb. Diversification and lower costs than managed funds.
Agreed -- Vanguard has a great model.
However, that's not the intended meaning of "dumb" in this context: Here, we are talking about 401K money that is blindly contributed, each paycheck, no matter what's going on in the market (even if the fund is massively overvalued). Because the investor doesn't "watch" the contributions, nor "adjust" the allocation based on market valuations, the market can "do whatever it wants", insensitive to those future investment flows. This typically describes the retail investor.
Of course, the investor isn't "stupid" -- he probably has a life, and other things to do, doesn't want to bother computing valuations regularly, and can't touch the money for decades anyway (i.e., it's "locked up" in the retirement account). So, this "auto-pilot" approach provides a "smoothing" algorithm where regular investments mostly "work out" in the long run (some paychecks were spent on things overvalued, some on under-valued).
So, "dumb" money should be assumed to be "money invested insensitive to current valuations". That is the *opposite* of what the financial industry pretends to do (e.g., weighting investments to sectors/funds/stocks/bonds based on valuations, for the sole goal of beating an index, or representing sector performance).
[EDIT] Oh, forgot to mention that there is a second meaning to "dumb money", which implies the aggregate class, like the aggregate inflows and outflows of the retail investor. This money *does* move as a category (e.g., the current baby boomer retail flow from stocks to bonds), but is consider "dumb money" since it moves as "rudderless group", like a barge adrift, without a "strategic goal" like might be assumed when a hedge fund might move a few $B into a sector. (When a hedge fund re-balances to sectors, it is intentional and strategic; when the baby boomers re-balance to bonds from stocks, it might be *individually* strategic, but as a retail class, it is blind movement.)
So, I guess I need to update my assertion: "Dumb" money is invested in aggregate non-strategically (insensitive to current valuations, and/or non-strategically as an aggregate class).
(...other thoughts on this...?)
(...Side note: IMHO, "dumb money" is kind of a misnomer, as it really implies investors without the "inside track/inside information". Retail investors do not have access to information like does the underwriters, nor access to market information like what's going on in "dark pools". IMHO, a better term would be "blind money". Although I concede the markets can quite often scare Granny into doing the *exact wrong* thing every time, in general, retail investors are not "stupid" as a cursory assumption the term "dumb" might imply -- rather, they are blind because they *cannot* see and do what the "professional" money can, and they don't want to waste their lives trying to optimize those decisions in a granular way like the professionals theoretically do.)
Greattime: Index-linked ETFs are explicitly dumb - the investment thesis includes an explicit admission of inability to pick stocks or sectors.
Mikla:
Retail investors are overall withdrawing from equities, but to the extent they're still in, which is not small, there is a clear shift towards ETFs, direct and indirect through pension funds and other funds that hold ETFs.
The financial industry is applying the strategy you mention but also increasingly is using ETFs, index-linked futures and options, and ETF-like HFT strategies, that assume any divergence is most likely to overshoot.
The volatility that I'm talking about is especially with individual stocks and sectors, as at some point, smart money will force divergence. When ETFs and similar lead the market up or down, bad or good stocks and sectors get carried along. When stock pickers buy or sell a particular stock or sector, ETFs and similar inherently immediately tag along, or capitulate, however you want to put it.
it's fashion week in NY.... doesn't that correlate somehow with a rat's ass as well...
there's a tiny little back dot floating above the horizon heading our way, could that be the "Black Swan...? I suppose that the turkeys are in a jovial mood right now.... Specifically the of the Treasury variety.
Best regards,
Econolicious
PS Iv'e missed the math problem twice so far.... WTF...!
me 2. then on third try answer, i put in a minus sign plus two digit numbers for answer. something like can't have 3 digits and it gave up and i got in.
And as for money managers all trying to build aum by beating the index, let me assure that is a minority. The majority are trying to preserve aum by making sure they don't get beaten by the index.
Couple of interesting posts over at Financial Sense - fwiw
http://www.financialsense.com/contributors/brian-pretti/you-dream-of-columbus
http://www.financialsense.com/contributors/d-sherman-okst/mutant-rat-epidemic-spreading-economic-black-plague
+1
Updated DOW weekly chart:
http://stockmarket618.wordpress.com
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Interesting to read all the new responses, thanks for all the current news and updates. Hope to read more very soon.
moulin farine