Correlation Station

Second best is never enough
You'll do much better baby on your own
--Madonna

Recently I've come across a few claims that movement between individual stocks is starting to disaggregate--i.e., to become less correlated. These claims haven't 'felt' right to me, based on my observation of the tape. It found me wanting for a Bloomberg terminal so I could punch up some correlation data.

Fortunately Jeff Saut did the leg work for us. The below Bloomie chart comes from his recent missive. Results indicate that since the May 'flash crash', correlations between SPX stocks has increased rather than decreased.

Jeff proposes that this is because 'dumb' retail investors have largely left the market, leaving daily action to the pros who are all doing the same thing. This seems wrong to me. For one, individuals didn't bolt out the door at one time, as the square wave higher in r-squareds would suggest in the graph. Moreover, we know that the 'pros' have all sorts of strategies likely to lead to differential positioning. In fact, one could argue that 'retail' market participants are more likely to follow the big guys rather than do something different.

If this chart would go back a couple of yrs, my sense is that we'd find correlations at least as high during the 2008-2009 period when more of the 'dumb guys' where more active.

Instead, it is likely that two other factors are exerting dominant influence on correlations. One is downward price movement. When prices fall, investors generally get nervous and sell indiscrimantly--Intel (INTC) gets sold alongside Johnson & Johnson (JNJ) et al. People reach for market indexes rather than individual issues, which causes stocks to move together. Volatility indices typically jump during downdrafts as folks pay up for insurance across the board.

The other factor that increases correlation is leverage. When leverage is employed to put on stock positions, small price changes in the opposite direction make people react sooner. Actions and reactions become more correlated as folks monolithically seek to relieve the pain of loss.

Couple downward price movement with leverage and you have a potent mix for high correlation. Relief rallies like we're seeing now are likely to lower inter-stock correlation. But as long as we remain in a highly leveraged state, then any downward price trend is likely to correspond to sharp increases in correlation.

positions in INTC, JNJ