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Record Correlations + Record Low Mutual Fund Cash + Soaring Dispersion = Recipe For Redemption Driven Disaster
The topic of surging market return correlation (and the death of alpha on broader terms) is nothing new to long-term Zero Hedge readers: every time the market appears poised to crash, stock and sector correlations reach new highs while return dispersion drops as fundamentals and technical are broadly ignored, and only the roar of the thundering herd matters. And while whether a spike in volatility is a precondition to correlation jumps, or simply a coincident factor, is unknown, in recent weeks an equity correlation of 1.000 has been matched by a jump in volatility not seen since the days of September 2008. What this has done is to make return dispersion for the hedge fund community higher than historical associated with comparable episodes of palpable market fear, exposing a broad rift between the outperformers (very few, mostly macro hedge funds) and underperformers (many, long-biased primarily). Curiously in the (massively levered) mutual fund community everyone is broadly underperforming with roughly the same intensity. Which means that while in the past one’s returns could suck, at least so would everyone else’s, the past month has accentuated the ability of funds to generate alpha (and even beta) lead to broad reallocation of capital by fund LPs. The will force the en masse selling of winners to satisfy margin calls, exacerbated by record low mutual fund cash "dry powder" positions, and sets the groundwork for even more volatility as all traditional hedging strategies fail. So what is an investor to do in such a confusing environment? Pray... is the short answer. As for the longer one, there is not much that can be done according to Goldman, which in its latest weekly chartology has little if any words of encouragement for both clients and market speculators alike.
From Goldman’s David Kostin, who first describes the latest record surge in correlations:
Correlation of market, sector, and intra-sector returns has soared to record levels as macro themes continue to drive equity market performance. Investors believe a high correlation environment is associated with low return dispersion. However, stock volatility has been elevated and a high volatility regime typically corresponds with high return dispersion. A high correlation and high volatility situation suggests mixed dispersion of returns. Indeed, dispersion of equity returns at the market and sector level has been slightly above average compared with the past decade.
The 3-month trailing daily return correlation among the ten major sectors hit 0.94 last week, the highest in more than 20 years, more than two standard deviations above the ten-year average and a level approached only once before, during the aftermath of the financial crisis in February 2009 (0.91). The sector correlation averaged 0.67 during the past decade and 0.58 over last 20 years (see Exhibit 1).
Correlation of returns across all 500 constituents in the S&P 500 index stands at a record 0.75, 3.1 standard deviations above the ten-year average. Intra-sector correlation of stock returns within each sector equals 0.78, a new high, and 2.8 standard deviations above the ten-year average of 0.49.
As for what hedge funds can do in this kind of market, the answer sadly is, not much
Three strategies exist for investors to combat a high correlation market: (1) Nimbly trade the macro news, although this approach involves high risk given the volatile global political and economic environment; (2) identify thematic characteristics that will drive relative performance, although sharp reversals have meant few strategies have delivered consistent returns; and (3) use a long investment horizon to capture perceived mispricing, although this approach requires a patient capital source to allow time for the disparity to close.
Translation: nothing in the hedge fund arsenal works in the current investing/speculative environment, where redemption requests in many cases soar after just a month (if not week) of underperformance.
What’s worse is that anyone expecting a moderation in correlation will be disappointed based on a realistic appraisal of what is coming:
The news flow for the balance of 2011 will continue to be dominated by geopolitical uncertainty on three continents led by the European sovereign debt crisis, ongoing budget negotiations in Washington, DC, risk of US recession, and slowing pace of economic activity in China. The trading backdrop certainly appears conducive for global macro funds to outperform given the key market drivers are primarily macroeconomic related.
Making matters even worse is that in addition to already much discussed margin calls sapping investor cash, mutual funds are levered to record levels as we noted first months ago:
And as the redemption requests start piling in, the slow money will be forced to proceed with a rapid liquidation of winning holdings (as gold experienced last week, assuming of course that the CME margin hike had not been leaked).
But are mutual funds really going to see a spike in redemptions? You betcha:
Global macro hedge funds have posted strong returns in 3Q and YTD. These funds have nimbly traded the treacherous environment with the typical macro fund returning 4% in 3Q with 2/3 of macro funds returning between - 1% and 9%. Macro funds have returned an average of 8% YTD through September 16th. These returns are impressive considering the huge price swings in equities, commodities, interest rates, and currencies in 2011.
S&P 500 index has outperformed both long/short equity hedge funds and large-cap core mutual funds YTD as of September 16 (-2%, -4% and -4%, respectively). Relative returns of long/short hedge funds was slightly better in 3Q (-4%) versus -8% for S&P 500 and -9% for mutual funds.
The painful 7% plunge in the S&P 500 this week has pushed the 3Q and YTD returns for the S&P 500 to -14% and -9%, respectively, as of September 22nd. Mutual funds have lagged the market, falling 15% in 3Q and 11% YTD. Just 30% of large cap core mutual funds has outperformed the S&P 500 YTD. We estimate long/short hedge funds have returned -12% in 3Q and YTD.
For style advocates, just 34% of large cap growth mutual funds and 46% of large cap value funds have beat the Russell 1000 Growth and Russell 1000 Value benchmarks, respectively, YTD in 2011 as of September 22nd.
The paucity of outperforming mutual funds and long/short hedge funds is surprising given dispersion of stock returns at the overall market and within sector level has actually been above the ten-year averages (see Exhibit 4).
As noted previously, correlation of returns is extremely high but the dispersion or range of stock returns is large in absolute terms. For example, during the past 30 days, while the S&P 500 returned 1%, the best performing stock in the S&P 500 (GR) surged 47% while the worst performing stock (NFLX) fell 37%. The range of returns represents the potential alpha generating opportunities that existed for both long-only mutual fund and equity long/short hedge fund managers.
We fully expect that the investing community will proceed to sell all of the best performing stocks imminently as this last bastion of cooperative game theory falls apart.
Yet in all this gloom there is some bad news: job prospects for FX traders and analysts have never been better, as macro has emerged as the only strategy (modestly outperforming the market if still negative) that matters.
Looking ahead, a normal return dispersion climate should mean security selection matters. But it is hard for a portfolio manager to focus on the nuances of stock selection when the prospects of a US recession keep rising and the outlook for the European financial system seems more precarious, not less, on a daily basis. Simply put, the macro is overwhelming the micro.
The biggest loser? Last year’s biggest winners – quant, HFT and algo traders (who are now much deservedly demonized on every down day and broadly ignored when the market trades higher), and their CEOs who suddenly find themselves without a compass or GPS in the most treacherous market seen in years if not decades, and with BODs intent of finding scapegoats. For the prime examples of this look no further than Goldman’s now former Global Alpha and ever more correlation (Insert Greek Letter Insert Number) prop desks blow ups (the irony of course being that if UBS had followed the stipulations of the Volcker rule, its CEO would still be in his chair). These are just the beginning, as the true severity of record correlation and investing leverage are gradually disclosed.
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'Simply put, the macro is overwhelming the micro.'
Isn't that really just the story of how farsightedness always has overwhelmed short sighted solutions? The 'quick fix' that has always ended up a policy of the neo-liberals looks good in a three month period but fails miserably over, lets say, a decade or so.
This latest 'deflation' scare is going to set us up for even worse solutions shortly.
The CME margin hike was not leaked. It was a result of Friday's trade.
Strange then that there was no hike in the /ES contract margin on any of the days in the past week. Yes, the CME determines the margin on the most popular stock derivative contract too....
You're stating this as if it was some kind of common knowledge. You cannot make such a claim. Or I guess you can, but you'd be wiser not to.
The CME increase was a result of Friday's trade? As in the good folks at the CME simply wanted to maintain sound orderly markets? Did you get that directly from the CME website? Do you have a 'hope and change' bumper sticker?
Why increase margin while the gold/silver prices are already going lower due to a general market crash and forced liquidations?? A: In order to prompt gold/silver to crash further.
The CME increases margin to aid and abet the bullion banks in managing their silver shorts. On Friday, like back in August, and like back in May for silver, the CME increased margin just prior to options expiry in order to smash longs.
The CFTC has chosen to allow this, because they are corrupt or stupid. Or corrupt and stupid. Be sure to drop them a line and let them know what you think of their actions/inactions. The only response you will ever get (besides some occasional platitudes from Chilton) is an autoresponse from Jill Sommers saying she is on vacation.
jsommers@cftc.gov <jsommers@cftc.gov>; MDunn@cftc.gov <MDunn@cftc.gov>; Somalia@cftc.gov <Somalia@cftc.gov>; ggensler@cftc.gov <ggensler@cftc.gov>; <BChilton@CFTC.gov>
Zero Hedge agrees with Rick Perry?
The most effective thing market participants can do is engage in prayer and fasting (less consumption means less net inflation)?
This is the banksters' endgame we're living through. This same time next year, if not earlier, the world will have changed thunderously.
Enjoy the last few moments of "normalcy".
Isn't about time we hear of someone breaking par?
That's quite easy actually. Get the President to play. President's bogey is Par for the rest of us.
How fitting, eh? Par is Far.
ORI
Uppers and Downers
Last I saw, he was playing with Clinton.
As with everything they do, their published scorecard has no correlation to the number of strokes that actually occurred.
Two take aways... 'pray' and 'massively leveraged'...
Does god care if a hedge fund goes belly up?
When the history of this debacle is written readers will marvel at the greater fools that were invested in highly leveraged institutions... But, will those readers readers of history connect to the fact that Fed/central bank policies have made risky investments the only game in town for even a modest return on investment?
Disclosure: Lots of pop corn, 'hurricane supplies', game getters, PMs, and an easy chair from which to observe the ongoing slo mo train wreck.
50,000 readers on Greek default, 100,000 go to bank on Monday
"100,000 go to bank on Monday"...
We can only hope!
Somehow the citizens of the world need to blow up the banker leaches...destroy their paper power and their strangle hold is broken.
"Does god care if a hedge fund goes belly up?"
Every time a hedge fund dies an angel gets its wings.
+100
Stack your put options and wait.
This is going to be an epic week.
Get out of stocks and into physical.
Meet you on the other side :)
The biggest mistake investers make is not during the buying process but during the selling process.
Rumors do not effect the buying as much as they effect the selling.
what is the exit point? = consternation
You're probably right, but I'm going to wait until S&P 1080 or so, and start buying calls for a short term rally. Ride it back up to 1220 and roll it all over into puts for the next big sell-off. But I'm probably wrong.
I find them too expensive now. I sold a few on Friday but couldn't find any to buy with the profits. I am afraid they are going to engineer a bounce somehow and nail the people who bought expensive puts.
Even my most out of the money puts are going to roar to the moon!
we wish to fail, its the only thing we hav'nt done. i hope its spectacler, let it begin. failer is the new new. take a look at rebecca black. this may be off topic but i think its where we are.
Quote "every time the market appears poised to crash..."
IT DOESN'T.
No one wants to take a hit until it's too late and the herd instinct kicks in.
Sell now buy back later if you like being in stocks.
Personally I like the shiny stuff.
Exhanges you can believe in!
Now, or;
Buddy can you spare some Change?
Bumper sticker: A redemtion a day keeps the bankers at bay.
I guess a major crash is fairly imminent.
Open Interest on SPX October Put Options a whopping 900,000 contracts.
http://www.marketwatch.com/investing/index/spx/options
I think normal open interest is maybe 10-15,000 contracts or less ...
Something major is definitely up.
Add this:
http://www.marketwatch.com/story/why-the-insiders-have-quit-buying-stock...
They have realized that the market is not near the bottom yet, just wait until the housing and consumer confidence numbers come out this week. I think it will be ugly. Hang on to your hat, might be another hell of a ride down....
Pray = kiss your ass goodbye.
When the formerly Inversely Correlated become Co-Correlated, the game is essentially over. Co-correlation can nearly always be seen before hysterical heights and sharp corrections.
75% sector correlation is ridiculous. How can Energy and Transport be co-correlated? Or Energy and Food for that matter?
Given the yield curve has pancaked after 7Y the only way out of risk markets is into the short end of the treasury curve. It would be good if there was a secondary market for commercial paper, but given that there is not, one could always go into MM funds.
The whole point of portfolio theory is the inverse correlations between sectors, throughout the whole business cycle, including recessions.