Correlation Anyone?

Any one that is close to the market can testify that stocks have developed an extreme case of herd mentality. It is more that slightly surprising that frequently there will be a move in the market and every single stock, and for that matter even many commodities, will be moving the same direction an approximately the same percentage as the indexes. There does not seem to be any type of news that can generate a mixed bag of up or down movement in the market. Was it that long ago, when good earnings from one company due to market share gains, was actually bad for their competitors? The market seems to be acting as the manipulated masses of a good advertising campaign – if Burger King advertises, McDonalds sells more fries.

So how does this affect the individual investor? Quite frankly, as long as the market direction is up, people are happy as the more correlated the returns are, the more likely that individuals will have a return similar to the indexes. This would be true if they have the "large firm typical portfolio of 10 – 30 different stock positions" or whether they are in mutual funds of whatever bench mark. There was an article on Sep 6, 2010 in Bloomberg that indicated that as of that date the year to date returns for six of the ten largest mutual funds had a correlation with the market of .99. That meant that none of their over and under weighting had net been at all statistically relevant. 

The problem with correlation is simply that markets do not always go up. Of the last two downturns in the market there were places to hide in 2001 – 2002. Small cap stocks and some foreign markets performing much better, but 2008? Not exactly. If you were not in Treasury bonds, you did not do well. The correlation was so strong that any amount of diversification simply did not work.

The CBOE is doing some very interesting work on the correlation issue and they actually have several indexes that track the implied correlation of a basket of individual basket components and the implied volatility of the index. Please reference that on their site for the details, but a few points to note is that both the actual correlation of that basket to the index, as well as the implied correlation of the LEAPS options are both going up. So, a very simple summation is that the actual correlation is increasing and traders expect this to continue. This despite the up market, as usually (and have to be careful with that word – as it is similar to always and never) markets are more correlated in down markets as high correlation is usually driven by significant macro events which usually are negative (peace rarely breaks out overnight, but wars and revolutions sometimes do). There are many theories as to why this is happening, from the most widely accused – the proliferation of index investment products, to the larger percentage of institutional (and less retail) volume, but my personal favorite is that the only real macro event that has mattered the last two years has been the action of the Fed. 

Last Monday was interesting with S&P putting the US Sovereign debt on credit watch, not exactly the peace breaking out scenario. Within hours the markets started to recover and in less than 48 hours, options as measured by the VIX were trading at a cheaper price and, by the way, at a new 52 week low. Does anyone really feel that two days after this event, that there would be less risk in the market than before it? So what had changed? Could it have been another significant increase in the money supply numbers, probably on the very day of any adverse news story, especially one that calls into question the Fed’s own policies? Weekly money supply numbers have been growing significantly and are now at all time highs. This growth is much higher that the scheduled QE2 purchases – so the Normal Open Market Activity – have been anything but normal. If it is, we have a few things we could have taught Rwanda.

So the way I see it – the Fed is designing the size and shape of the pool, the big guys that actually conduct the Fed activity in the market are the sharks and the rest of us are the little fish that swim along side and get the crumbs. It could be a good life if we are quick enough to get out of the way on the quick turn of the sharks when the main course dries up. 

So how do you deal with this? The first is the ostrich approach. I can see it and understand it and if your time frame is long enough you can depend, to some degree, on the fact that the economy is still growing and probably will continue to and there certainly are powers that are doing everything they can to make thing go your way. Keep in mind the last down turn proved that a ten year time frame was nowhere near long enough and you still have the risk of a small consistent dollar denominated gain not being enough to out distance the current dollar depreciation. The second is to relay on market timing, with the intention of a relatively large move to cash at the opportune time. This we believe is a bit optimistic that you would see it, recognize it in time and have the courage to move enough assets out of the market to make a difference, as a move early could trap you in cash. That being said, this approach would have worked as well as the ostrich the last two years. With this approach I must share a story.  I had a client in the early 90’s that was fully invested and some sort of downturn was occurring. I mentioned that he should do some risk management and he said he had that covered. Now, more than a bit curious, I inquired and he told me that he was paying monthly for a service that was going to send him a fax before the next crash (just imagine how this service could sell now with email and smart phones), and I asked him if it was working and he responded that, so far, he had not received a fax and the market had not crashed, so he had that covered.

The approach that we use at PTI Securities is to have long positions in ETF’s and to maintain LEAPS put protection at all times. We also attempt to offset the cost of the put protection with a covered call writing program. In an extremely quick and highly correlated upward movement in the past two years, the put protection has been a drag on return as any hedge would have been. However, this eliminated the worry that the market might not give you the opportunity to see that next negative movement coming (maybe you are on vacation when the fax comes in) and since you have insurance, you are not consumed with the huge “ALL IN or ALL OUT Decision” constantly pending.

Whatever approach that you are choosing, there are risks out there that are just not being addressed by the standard diversification and long term mentality (an even scarier discussion is that the correlation of the market is now creeping into commodities and just about every other asset class, so we have something to look forward to).  

Daniel J. Haugh
PTI Securities & Futures LP