As Stock And Sector Correlation Hits Fresh 20 Year Highs, Here Is Who Is Benefiting

Tyler Durden's picture

There was a time when being short was a bad idea. Not anymore. As David Kostin' summarizes in his latest weekly chart packet, the level of 3 month S&P and sector correlation is now at a 20 year high, an environment which never leads to good outcomes for long-only whales, and which has led to sizable outperformance for hedge funds due to their recent loading up on short positions. To wit: "S&P 500 three-month correlation is 0.73, the highest in at least the past 20 years, and up from just 0.44 at the start of August. Sector correlation is similarly high, with all major S&P sectors experiencing realized correlation above their 95th percentile since the late 1980s. While it is difficult to specify a cause for higher correlation, a spike in S&P futures and ETF trading volumes and parallel reduction in open interest held by institutional and levered funds as reported by the Commodities and Futures Trading Corporation (CFTC) indicate significant de-risking in August." What does that mean for recent performance? Nothing good if one is a mutual fund: "Elevated correlation is generally considered a poor environment for long-only fundamental investors. In highly correlated sell offs the market does not discriminate based on company fundamentals, reducing the value of stock picking. Recent performance trends support that case." As a result hedge fund LPs are doing ok: "The typical hedge fund has generated a 2011 YTD return of -1% through August 19 compared with a -10% decline for the S&P 500 and an -11% return for the average large-cap core mutual fund." Alas, if the hedge fund in question is Paulson & Co., this average statistic is very misleading.

Some more:

The 2011 hedge fund return story has two chapters. Hedge funds trailed during the first-half, posting flat returns on average with a 550 bp standard deviation while the S&P 500 rose 6% and mutual funds advanced 5%. However, the correction has pushed the S&P 500 3Q-to-date return to -15% as of August 19, while the typical hedge fund returned -2%. The distribution is wide as about 10% of funds returned 10% or more and 10% were down at least 10%.

What are hedgies holding?

Hedge funds are most overweight Consumer Discretionary, Info Tech and Materials. During the quarter funds increased their allocations to Info Tech and Discretionary by the largest amounts and decreased positions in Health Care and Industrials. Contrary to our recommended sector weighting, funds are underweight Consumer Staples and overweight Consumer Discretionary shares, a view also held by large-cap core mutual funds.


Hedge fund holdings of large-cap stocks continued their ten year trend higher. Roughly 47% of the aggregate assets of hedge funds is invested in stocks with equity capitalizations greater than $10 billion as of 2Q 2011, up from 35% in 2002. Just 18% of aggregate assets is invested in small-cap stocks (below $2 billion). The typical hedge fund allocates 35% of its assets to large-cap stocks and 33% to small-cap stocks. The difference between the average and aggregate suggests that the hedge funds with the largest assets under management target large-cap stocks.

Shorting helps offset massive losses:

The typical hedge fund short portfolio has helped offset losses. We estimate that hedge funds account for 85% of all short positions and construct a proxy of the “typical” short portfolio. Those short stocks have been an effective hedge by underperforming the market but have actually outperformed the typical fund’s long positions. Funds reducing gross exposure by selling longs and covering shorts is one possible explanation. Single stock short interest declined in early August even while index level shorts rose (Exhibit 8). The short portfolio is down 18% since June 30 and 13% in August vs. the S&P 500 returns of 12% and 10% respectively.

Of course, it wouldn't be a Kostin report without the now traditional dose of empty hopium:

We see faint signs of market stability as large mutual fund outflows stopped last week, options imply lower correlation over the next three months, and the S&P 500 has settled into a range between 1120 and 1200 over the past three weeks, albeit with high intraday volatility. The average intraday trading range has been 3.5% in August, more than triple its average during the first seven months of the year

And some of the key charts:

Full report:

Kostin HF Performance

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CrashisOptimistic's picture

When cross correlations go to 1.0, this is a rather loud noting of the obvious: there is nowhere to hide, sector-wise.

It's not a market anymore.  It's an exercise in predicting government intervention.

gwar5's picture

Exactly. It's an exercise in predicting government intervention. And getting harder to distinguish from economic fascism.



narapoiddyslexia's picture

Don't the massive cross-correlations across thousands of distinct, individual invstments necessarily imply that the robots are running the insane asylum?

Bay of Pigs's picture

You can hide in the PM sector. Gov't intervention is gasoline on the fire.

Stuck on Zero's picture

All the shorts are getting scared out of the market by massive interventions.  That leaves only bulls. 

Implicit simplicit's picture

Machines have no emotions. They are visual stop chasing predators that go in any direction.

unununium's picture

Being short simply takes confidence, and risk management.  I've been net short equities since October 2009 and, believe it or not, have not gotten killed.

You think the market is artificially supported?  That is an excellent argument for shorting it.

Implicit simplicit's picture

Wall street is a bunch of frightened investors that collude for short term profits by creating squeezes and trend momentum, They are frightened because they realize it is the end game, and they will do anything in an attempt to keep the status quo. Anything. The more dour the economy becomes, the more colluded corrupotion that will occur. It is the fight or flight theory for survival in action. It is a code of silence which the SEC realizes. The SEC, wall street and the  banks need the Ponzi to continue for as long as possible. Help them by becoming their prey.

Captain Benny's picture

Well said.   I've heard people "in the know" comment on how traders are shitting bricks just worrying about their jobs and hoping the ponzi continues long enough for them to make a new bonus.

The volume has dried up and there is nothing but manipulation pushing the indexes higher.  Its disgusting.  Doesn't need to be said, but you and I and everyone we know needs to get out if we're still in.  The "shocking" wave of deflation is coming and then quickly we're going to see that its hyperinflation that we've got to be worrying about.  Anyone storing dollar denominated assets is in trouble.... the only good place to be is holding your own personal debts in dollars and holding your assets in the tried and true currencies of gold & silver.

I expect a TBTF bank failing within two months... probably by late Sept.

gwar5's picture

Without QE3, what else is a poor boy on Wall Street to do except go a little short the market? I agree with ZHer below, CrashisOPtimistic -- "It's an excercise in predicting government intervention."



disabledvet's picture

Intervention has come in rhe form of state and local governments. All else is simply a bald faced short selling "i got fired for cause" lie. There has never been any intervention in this market nor will there be as it corrects. There could be a massive MILITARY intervention in say "the failed state of Mexico" but i fail to see how that would solve the problem of a major credit event in say...Ohio...let alone...Germany.

Jovil's picture
John Exter’s Inverted Pyramid of Assets

We should move Government Bonds to a less secure classification closer to credit default swaps.

John Exter’s inverted pyramid. The idea is that things high on the pyramid are derivatives of asset classes further down the pyramid.

greased up deaf guy's picture

yet gold is up about 30% ytd. i'm not gonna lie... it feels good being right.

janus's picture

it is easy to grin/

when your ship comes in/

and you've got the stock market beat/

but the man worth while/

is the man who can smile/

when his pants are too tight in the seat

The Deleuzian's picture

broken market, broken political body translates into misery for zounds!!

self reliance, common sense, confidence in self and those close to you is the only antidote!!

janus's picture

Mr. Durden,

thought i'd take a break from digesting all this and share something with you:

i googled the following words (without quotes): stock correlation.

a ZH article was third on the list...i've been noticing that a lot more lately; and it seems to be gathering quickly. 

maybe just a coinicidence; thought this may be of interest.

janus's picture

fellow neophytes,

this may be of help if, like janus, you are stupid but insist on knowing in spite of yourself.

why didn't TD tell me about these things when i started this trek months ago?

now i've got to go back and regigger my whole plan for the upcomming week; this pretend trading is tons of work.  actually, these correlation numbers seem to work better for developing an overarching strategy...i guess the way i see them is as an indication of a market's future secular state...or, on second thought:

okay, i just went back and studied some more.  wanna know what jumps out like a spring-loaded jack in the box with an electrified stinger? oil.  something particularly anomolous about a commodity that has positive correlation with EVERY fucking asset class. 

you know, gentlemen, this manipulation racket isn't so tough to figure out; just beware excessive leverage -- and don't get too cocky about timing.  let them keep giving us money.

okay, oil market, brace yourself -- janus is going to pretend play you starting this week.  i mean, am i missing something here -- or is this stuff a lot easier than i was thinking in the beginning. 

but, on the REAL real, janus bought bunches of silver last week in the low 39s...i was just sitting there, watching the market, thinkin, 'it would be mighty nice to buy some under 40 one last time'; and, as if from my mouth to God's ears, BOOM, three dollar drop in like an hour (not afraid of a falling knife when were talkin silver under 40).  i'm looking forward to the day when i reach the first stage of my silver sell strategy and can start hikin skirts all over wall street.  i know i don't have paulson's billions; but, the way i see it, it's far preferable to be a very small skirt hiker than to be a giant caught helpless with a micro-mini sans panties (eh? paulson).