Monday, August 29, 2011

Guess I Should be Working at Goldman - Note on Correlation Almost Identical to My Article Last Week

Last week in [Aug 25, 2011: Student Body Left, Student Body Right Trading Returns as Correlations Surpass that of Even 2009, 2010] I wrote

The past few years has not been a fun time for 'stock pickers'.  Correlations have risen to record levels, as everything has turned into a 'macro' trade much of the time. 

Combined with the dominance of computerized trading (now accounting from anywhere from 50-70% of all volume) and EFT trading (where the individual components are all treated as one in a buy and sell decision), and we have both structural and cyclical changes happening in the market.

then I plucked a chart out of Business Insider.

I've actually been citing this trend (bemoaning it actually) for a few years, and pointing to EFT + HFT.


Goldman Sachs was out with a note Friday which is almost identical in nature to what I wrote last week.

  • The correlation of moves in individual stocks and the S&P 500 index is at a record, making the job of long-only mutual fund managers to differentiate from the benchmark virtually impossible, according to a report from Goldman Sachs.  (My note: I'd argue not all mutual funds, just those focusing on large caps and perhaps mid caps)
  • The correlation for the S&P 500 and its members is at 0.73, according to Goldman, meaning that the majority of stocks move in lockstep with the index on a daily basis. This is at least the highest in 20 years and therefore likely a record.
  • "Record high S&P 500 and sector correlation poses a challenge for fundamental investors," said David Kostin, chief U.S. investment strategist at Goldman Sachs, in the Friday note.  "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," Kostin said.
  • With their ability to go short during the most recent stock market selloff, hedge funds  have cut their losses on the year to just 1 percent on average, according to Goldman. Meanwhile, the average large-cap core mutual fund is down 11 percent in 2011. No wonder, considering the pressure on mutual fund managers to stay fully invested so as not to miss any rally in the benchmark. The cash-to-assets ratio for mutual funds is at a record low of 3.4 percent, according to the Crosscurrents market newsletter.
  • Kostin and other traders believe this lemming behavior among individual stocks could be attributed to the popularity of exchange-traded funds, which allow investors to trade whole indexes and sectors as easily as individual stocks, and the surge in lighting fast high-frequency trading, the buying and selling of millions of stocks in milliseconds based on algorithmic models
  • Assets in ETFs  have topped $1 trillion this year. Some market analysts estimate computer trading has accounted for 70 percent or more of the market volume as of late.

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