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Why Record Stock Correlations Are An Adverse Feedback Loop To Market Participation
The ongoing retail abandonment of stocks is well into record territory, which may occur for any of a variety of reasons (need for cash via redemptions, focus on return of capital than on and shift into fixed income, market distrust, etc.), yet the resulting increasing relative participation by electronic feedback loop chasers and by beta levered players, and the subsequent increase in implied and absolute stock correlations may be a vicious circle that will make future retail participation increasingly more difficult. We have been warning about the threat of lack of stock diversification for many months, although have not been able to explain it as succinctly as BNY's Nicholas Colas succeeds in a recent note, titled "Looking for diversification in all the wrong places", in which he concludes: "If you cannot use diversification to manage incremental risk, then why would you take on risk in the first place?" This hits the nail on the head in terms of the ongoing and future lack of stock inflows, since in simple terms in makes the ever greater correlations between various asset classes a barrier to entry for all those very rational investors who seek to diversify bullish or bearish bets with a matched trade. In other words, the market is receptive only to those who blindly wish to bet it all on black or red (with or without leverage). And with ever more people chasing ultra short term return horizons (think numerous underperforming hedge funds that only have one month left to generate some returns in Q3 before their LPs send in the redemption notices), and placing all their bets on just one side of the line, those who wish to pursue rational trades, and generic long-short funds, increasingly obsolete and redundant. All in all, this is a perfect storm for a feedback loop that selects only for those who are willing to bet on an ever more one-sided, and thus unstable, market. Have we gotten to the point where only another market crash will provide retail with suitable speculative entry points?
Much more from Nicholas Colas on this fascinating topic:
Our latest monthly review of asset price correlations finds little changed in terms of equities: average correlations are a minimal 5 basis points higher than last month and continue to be stubbornly high. Precious metal correlations to stocks were little changed, with de minimis movement between asset classes, while foreign and emerging market correlations remained near historical highs. In terms of fixed income, high yield corporate bonds saw a dramatically lower correlation to equities, while the commonality of investment grade debt to equities spiked. Of the currencies we track – Aussie Dollar, Yen and Euro – only the Euro displayed significant change, increasing 30 percentage points in its correlation to U.S. equities. The bright spots here are that gold and silver are doing yeoman’s work providing much-needed diversification to investors who own them, and the Euro’s behavior suggests that the market is less worried about sovereign debt risk hitting that region in the near term. As a larger point, we still find that market correlations are a real impediment to a sustained rally in risk assets. If you cannot use diversification to manage incremental risk, then why would you take on risk in the first place?
Whether you want to admit it or not, you’ve likely done it at least a few times; you’ve put your own name into the Google search box and pushed “Enter.” Was it vanity? Or curiosity? Or did you realize that your employer/spouse/friend probably does it anyway and you should know what they see?
Regardless of motivation, unless your name is truly unique, your search will result in a very off-putting realization: lots of strangers have your name. Like your exact name. Most people, we suspect, could have a pretty good sized dinner party with people that live within a few hundred miles of their home and share their entire name.
Google “Beth Reed” and you’ll see what I mean.There are dozens of “me.” Maybe hundreds. All with the same name, but obviously completely different. Beth Reed, social work professor. Beth Reed, college soccer player. Beth Reed, pianist (entertainment for that dinner party, perhaps). Beth Reed, desperate job hunter. Beth Reed, cellist (wonder if she practices with the pianist…).
If you know me, you’ll know that I share very little in common with all the other “Beth Reeds.” Same with my Google images search – lots of Beth Reeds, but none who even come close to resembling me. (Scratch that whole “perfect crime” scenario where I have a long lost twin out there in the world). Actually, as a side note, I was kind of pleased to find the #2 Google search result was, in fact, really me. Granted, it’s a link to my Facebook profile (don’t click it, it’s blocked) and not some incredible accomplishment or noteworthy website. But of all the Beth Reeds on Facebook (and there are plenty), my profile popped up right at the top.If stocks, bonds, currencies and commodities could Google themselves, we bet they would all feel some of the same consternation that I do looking at all these total strangers with MY name. Sure, they all think they are different. Different fundamentals, different cyclical money flows, even different cultures and languages. But many of them really answer to the same name. I’ll explain in the remainder of this note.
Every month we track asset price correlations for a variety of financial assets as well as precious metal commodities. This month shows little break from the recent highly correlated price movements amongst these asset types. There are a few exceptions – we’ll note those in a moment – but by and large a whole range of disparate risk assets continue to trade as one undifferentiated mass. It’s almost as if you typed in “investments to buy” into Google and got pictures of a gold coin, a chemical plant, a 500 Euro note, and the exchange traded fund for U.S. banks. They aren’t the same – not by a long shot – but to the global capital market they all LOOK the same.
That’s not a healthy market. The mathematical benefits of diversification require assets that exhibit low-to-no correlation amongst themselves. When everything moves in synch, asset allocators have to pull in their horns. Wonder why investors are shunning risk and buying bonds? Part of the reason is clearly that the historically proven benefits of diversification just are not working as well as they once did.
U.S. equity correlations among the 10 industrial sectors of the S&P 500 remain near historical highs, as 7 out of the 10 sector ETFs show correlations with the S&P 500 in excess of 90%. Only Healthcare, Utilities and Consumer Staples are lower, and they’re stuck in the 80% range, which is still very high. During August, there were 3 notable moves among the sector ETFS:
- Healthcare stocks’ (XLV) correlation with the broad index fell almost 4 percentage points, while sector returns were down 1.1% over the same time period versus -4.7% for the S&P 500 .
- Consumer Staples (XLP) saw correlations increase more than 5 percentage points, a little surprising although 4 of its top 10 holdings that together make up about 20% of the index are down over the past month (CVS is down 11.43%, for example).
- Correlations of financial shares’ (XLF) increased 4 percentage points, which is understandable since concerns surrounding bank balance sheets and financial regulation are among primary drivers of current stock market weakness.
Precious metals’ correlations to stocks – we track gold and silver – were mixed last month. Silver was basically flat, while the gold correlation to stocks rose 7 percentage points. Both are hovering close to where they theoretically should be – silver (represented by SLV) around 45% (roughly half of silver demand is industrial) and gold (GLD) relatively close to zero at 13%. In short, it appears as though precious metals are among the few asset classes that are doing what they are “supposed” to do – diversify risk versus financial assets.
Foreign and emerging market correlations continue to stick near historic high correlations, with their respective ETFs (EFA and EEM) showing price correlations in excess of 90%.In fixed income land, high yield bond (HYG) correlations with U.S. equities fell 25 percentage points, largely as a result of stock market weakness over the past couple of weeks versus still decent bond market strength. In contrast, investment grade corporate bonds (LQD) saw their correlation rise almost 30 percentage points.
Of the 3 currencies we track – Aussie Dollar (FXA), Yen (FXY) and Euro (FXE) – the Euro’s 30 percentage point increase in its correlation to U.S. stocks was the only significant move. It would appear that, for better or worse, the fears over a European sovereign debt crisis have receded and been replaced with a more general global macro set of concerns. Hard to read that as really positive or negative at this point.Lastly, if the S&P sector ETF correlations over the past year are any indication of what’s in store, chances of a significant, lasting market rally appear rather slim. As the last 2 charts show, sector ETF correlations tend to break down and widen when the market is in the midst of a sustained rally, as it did in April and January. Currently, the 10 sector ETFs are bunched together, and though the difference between the high and low correlation has widened slightly, the average correlation has barely budged.
We hope this topic gets much more discussion in the mainstream media, as the implications of these observations are that pretty soon trading stocks, and pretty much any underlying assets will be completely useless, as an investor can get the same risk exposure by buying an ETF of the entire market, such as the SPY. Another tangent is that we have now reached a state of complete tail-wags-the-doggery, where the synthetic determines the prices of its constituent, underlying assets. However, don't tell all the ETF managers out there: if it is discovered that incremental diversification leads to a potential beta delta (yes, a lot of non-insolvent Greek) differential of just 10%, as 90% of beta is now inherent in all assets, this will soon make all vain attempts to pick off beta, let alone alpha, irrelevant. It will also kill all interest in purchasing individual stocks, especially in hedge strategy. We are concerned that this will mean outflows from all non-beta based strategies accelerate in the weeks and months ahead.
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Isn't that a result of all the pair trading.
I think the suggestion is that it is a result of this now being a closed-loop system whose only source of funding are its own gains rather than any additional money (e.g. inflows) from the retail investor.
Apparently they have found critical mass to start the chain reaction, though! I wonder what will happen when all of the U-238 is fissioned.....................
Another bailout most likely. I mean, how much could it be...
A little levity after a brutal day...keepin it real.
http://www.youtube.com/watch?v=fZa7hU6tP_s
Turd.. VXX and be patient. Get out of TBT on the next spike and wait (who knows how long) . Don't fight the Gulag....
Thanks Turd.
I suppose at a time like this, we should be thankful for the daily divergences between carry, treasury funding and good ole' equities. Without this, we would be reduced to coin-flipping...
And I spend enough at the Wynn already, thank you.
Heads...GDX, tails..GDXJ
Today was attempt to stop the outflow of retail from equities.
We shall see over the next few weeks if their planned worked.
I doubt it will. A crash will only hasten the exit.
Game Over.
Game over indeed. When will the rest wake up? It's time to pull out of this fucking fascist casino gulag corporatocracy. If you have money in the TBTF banks, pull it out, put it in credit unions. If you own stock, get out now, if you're interested in gold, take physical delivery. These scumbags have looted and stolen enough. We need a global movement for justice and the only way we find justice is by being proactive.
I've started down this path, strategic default with the evil bank and all free cash into PMs. I'm done getting fucked by banksters.
The market crash is hard to imagine. If all retail and institutinal investors/speculators leave the market place, then the FED and its affilliated international banks will just play the stock market to keep the quotes published at certain levels. How hard is it for them to keep Dow at 10000 for perpetuity. Their very physical existence depends on the stock market as psychological benchmark. They will do anything to keep their heads from being cut off by the angry mobs. Not sure how do you expect a market crash in thin volume trade with FED having unlimited money reserves.
A market crash requires some catalyst event, like major institution failing, a sudden war, a massive terrorist attack, or a medium sized nation to default. But all of these factors are in the hands of the international bankers. I will go as far as saying that all market crashes, terrorist attacks, wars and defaults is just part of long unending script managed and orchestrated by these guys we all so love. Why do you think, they will let a market crash happen when they don't need it and when they control everything.
While not hard to imagine you are right on why the stock market will be artificially propped as long it is at all feasible. The same with home prices. However, it does not take an overly creative mind or a steady supply of magic mushrooms to map out when such feasibility ceases to exist in any rational fashion. Depending on where things are politically and globally at that point in time will largely determine our future success as a Republic.
The Fed will only play equites in camoflauge. They will wash out with the tide or don new camo. The libs are at risk otherwise.
"then the FED and its affilliated international banks will just play the stock market to keep the quotes published at certain levels. How hard is it for them to keep Dow at 10000 for perpetuity."
Yea...the Japanese tried that in the 90's. Their market is down 70% from it's all-time high...over ten years later. If printing money to create wealth was that easy, perhaps a generation or two before us might have thought of it. Many have tried, all have failed, and there is nothing to indicate this time will be any different.
BTW - 1 in 8 Americans are on food stamps. What were the latest numbers for housing/car sales? The DOW is at 10,200. We are in debt we can never pay back, and our citizens can't feed themselves. Catch my drift? The DOW can go to 30,000 but if these numbers get worse it really doesn't fucking matter eitherway.
Or a voter revolt this fall that places a seed of doubt about FED policy...
The fed does not care about the market. They are only lending money to people who want to avoid the down turn / crash.
The fed only cares about making money and being paid back.
Paid back for what? It's not their money. They're focused on New World Order...
With my hammer, every asset class looks like a nail. Full disclosure: I am not your President.
Put plainly, every asset class looks like a taxable event, event not required. Full disclosure: I am not your President
Not unless the crash brings the S&P below 420
An Overview of China’s Fake Mortgage Loan Industry
http://israelfinancialexpert.blogspot.com/2010/09/chinas-shark-loan-ponzi-finance.html
Now we just need a Captain Kirk to force the feedback loop into a self-destructive phase. "You destroy all that is imperfect, yet *you* are IMPERFECT!"
http://en.wikipedia.org/wiki/The_Changeling_%28Star_Trek:_The_Original_S...
Maybe that is what happens when they have nothing else but themselves to shill-bid into electronic oblivion.
Tomorrow will probably be a "Risk Off" day.
This looks ugly...
This one looks good:
what are you saying?
email this chart printer-friendly format email this chart printer-friendly formatIt took two generations after the Crash of '29 for the public to overcome its aversion to equities. Growing up in the 60's and 70's I clearly remember the use of the word "broker" by my Depression Era grandparents as pejorative and "stock market" as being synonymous with gambling. After another generational collision with reality we are witnessing the birth of yet another aversion cycle. This time the cycle could well sweep away the ubiquitous mass delusion of fiat "money". Until the next time, of course. History repeats because human nature never changes.
Great excerpt from a Financial Intelligence Report newsletter I received regarding all the 90% up or down days with the best explanation of what happened today, I agree completely:
"What it means is that the street has programmed their computers to be "all in, or all out" at once. They know that the long term outlooks is dismal, so what we have in a nutshell is that the ENTIRE MARKET IS BEING DAYTRADED. You heard that right folks. Forget fundamentals, forget earnings, forget book to sales, credits, debits, assets and all the things that "used" to be important. Right now the way the street makes it's money is by whipsawing the market at incredible speed."....
"MYFOXNY.COM - If you think you've been seeing more people sleep on city streets, statistics back up the perception. The homeless population living on New York City streets has gone up 50 percent in the past year, according to city statistics reported by the HellsKitchenLife.com blog.
Whoa. More people living in the streets? Yes. In fact tent cities are popping up all over. In select areas, the best bridges to sleep under have become something of a high priced real estate holding. People are paying other people for the right to spend a night under a bridge. Now somehow I'm asked every day to believe that we're in an expansion, and that it's an incredibly strong one. Okay, pull my finger.
Look folks, the bottom line is that we are seeing all these 90% panic days because the market is now programmed to make it's money on high frequency, "all or none" in and out trades. They know the future is bleak. they are NOT buying and holding. Only the poor suckers who have their money parked in 401K funds, where the manager of that fund is indeed fully invested are "in for the long haul". The smart money, the movers and shakers are daytrading the whole damned market. Up 200, down 200, up 260, down 170... it's GS, JPM, CITI and the rest of the "boys" going ape.
You guys know I like to focus on the "fraud" that has become our market and nowhere was there more evidence of outright fraud than on Tuesday into Wednesday. If you pull up a chart of the last two minutes of trading for Tuesday, you see this insane fat green bar, so big.. so fast, it literally "gapped". Well the data shows that in those last two minutes on Tuesday "someone" bought 200,000 contracts. Now, a normal volume for that time slot would be maybe just 25K. Why would someone wait all day, and then jam a 200K contract order?
Wednesday morning the futures were up over 100. Why? According to the genius's on CNBC it was because of better manufacturing news out of China. Now that would be a wonderful explanation, except for the fact that the Chinese market didn't like the news. So, why should we be up 100 when the Chinese market themselves didn't get excited?
No.. this was not about China, it wasn't about Obama making believe we're "all" leaving Iraq. It was one of just two possibilities. 1) they have fudged Friday's jobs number and then leaked it.. or 2) the Fed directed the institutions to "save the market". That's all it could be folks. In fact, this morning while seeing the DOW up 120, the ADP empoyment report hit. They were looking for a gain of 13,000. Instead they LOST 9000. Yet the market didn't blink.
That my friends is FRAUD. Manipulation. They are in total control of this market and they "make" it move to where they want it. Granted they can usually only do it for short periods of time.. and then it has to revert to a bit of reality. But it sure is discouraging seeing that kind of action, where "someone" buys a quarter million contracts, and then "like magic" the market is u 120 the next morning. I guess I didn't get the memo that told me to buy several million dollars worth of options, so that I could make several million in ten minutes the next day. By ten AM we were up 240 points. If you think that someone bought 200K contracts because he "felt lucky" I got a bridge to sell ya. That my friends was inside info.
Okay the question of the day however is this... is this a one day flash in the pan or not? If you remember back to Friday, we had a 170 point day. then Monday we gave back 150 of it. Wednesday was flat. Now today they put on the ultimate show. but get this.. August was a pretty lousy month for stocks, yet on August 2nd, the first day of the month trading.. we gained over 200 points. Is the same thing going to happen now?
My best guess is that "they" are trying to show people that September doesn''t have to be the worst month of the year, and they're going to try and hold it up. But I also think that to do it, they'll almost have to come right out and admit to the fraud. Yes they can jack us up or down for a few hundred when they please. But to keep it really going, they'll need to buy those 200K contracts every day.. even for the Fed that's a lot of money to hide.
I don't know if we're getting set up for a massive rug pull on jobs Friday.. or.. if they have jiggered the numbers for Friday, and they're going to boom us higher for another few hundred points. Either situation is perfectly plausible. So, this morning we covered our shorts, and sat tight. If they want to try some show of bravado for September, fine we'll go long, I have several names I think can move well. But, if this is just a flash in the pan, I didn't want to go long, and have it all tossed in my face in a day. "
My thoughts:
Today may have caught a number of investment managers flat footed, they must match or beat their benchmarks (tough if in cash today) so higher beta might pick up again for the managers to try and make it back (doubling down).
This is a prisoner's dilemma, if we all agreed to go only long in the market for the next five years we would all be paper rich and pensions could be fully funded (baby boomer cash outflows for living expenses and unemployed is also a problem). Perhaps OBAMA SHOULD SIGNAL NOW IS A GOOD TIME TO GO LONG IN THE MARKETS like he did last year since they are clearly supporting the market (the problem is we don't know when they do it and when they step aside). At least that way individual investors could also participate instead of all the coordinated banking outfits manipulating up and down and eating through stop losses (they benefit from the volatility). See folks, the volatility benefits them in the short run and as we saw from the melt down last year these people are not long term thinkers. If the market continues with extreme volatility and drops without intervention, it will collapse because people will run to safety (mutual fund outflows). Traders are sharks, not gardeners so they are not developing a market with increasing customers. Derivative leverage reform and dark pool transparency could fix that if we wanted a real market.
The most difficult thing for me is knowing intention. I know they want a one world global currency and would also like to pick up assets on the cheap with a view to control the ownership percentage of all assets (they become landlords of the world) with paper that can't be audited. They already have all the paper money since they own a printing press that is not audited - so they want to trade this (and US$ debt) for real assets whenever they can before the $ collapses. The bankers have previously colluded to reduce credit which they knew would collapse asset prices and the economy (in the congressional record) in order to pick up (foreclose on) farms and homes west of the Mississippi. As Charles Lindberg said, from now on (after 1913) all cycles of deflation and inflation will be planned. You see, it's inflation first (increase interest payments and debt), then deep deflation (they take over real assets - right now banks own more houses than people do!!!), then rapid inflation to wipe away their balance sheet debt while they are left with the assets. So is it a replay of the ownership game plan, or is there so much risk from revolution/collpase that they will actually fully support the market? Are we in the midst of a global financial war, and if so it would be better to have a non-globalized market with no insane 40-1 leverage for individual investors (capital restrictions on hot money from overseas in and out)?
Will financial asset classes and currencies go to a correlation of 1 = a planned global centralized currency / asset hybrid? With a basked of commodities linked to SDR's, can we add Commodities to that correlation? Will market fixed income yields and equity dividend yields converge?
Based on portfolio theory, returns from the last 10 years, and the fiduciary prudent man principle PENSIONS MUST ADD PRECIOUS METALS TO PORTFOLIOS - Because adding the asset (backtesting) would increase returns while decreasing risk (less correlation), the same argument used for hedge funds a few years ago.
Too many questions, not enough answers, and too much uncertainty causing chaos.
I thought this was a great update on where correlations are - I dont think people are getting the relatively low absolute value correlations in HYG and LQD, not to mention GLD, SLV, and FXY. The bigger message is that all equities are correlating, but we shouldn't ignore the other asset classes.
Because I'm a visual kind of person I put together a graphic showing the overlaps between asset classes to show correlation - GRAPHIC - it's anyone's guess whether the circles are going to go closer in or further apart.
I often wonder why I bothered to buy more than one stock. They always move the same way. If Mr. Market is happy they all go up. If Mr. Market has a cow they all go down. If I could predict Mr. Market's mood I would just ditch all my stocks and trade the E-mini all day. Obviously pairs trading increases the correlation among paired stocks. Sector ETFs do the same for all stocks in the same sector. (When people buy or sell ETFs all stocks in the basket get bought or sold, good, bad, or indifferent.)
Come to think of it, the E-mini itself is probably increasing correlation among stocks. Futures prices can't get too far out of line with the underlying assets or arbs jump in and lock in risk free profits. Total trading volume (by dollars) in the E-mini actually exceeds total trading volume in the underlying S&P 500 stocks. So when the futures get bought or sold all 500 stocks are going to bounce up and down in unision.
The march from managed accounts to index-linked ETFs has to be the main reason for increasing correlation.
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