Monday, July 19, 2010

Correlations: "Stock Synchronicity and Future Returns" (SPY)

There was a flurry of commentary on reports of hyper-correlation in the markets last week.
(I know, I'm all atingle too!)
MarketBeat had as good an intro as anyone:
Stock Pickers Overwhelmed by Indexers, ETFers
Good story from MarketBeat cubicle-mate E.S. Browing Monday explaining a bit about why you can be a brilliant stock picker and still get killed in this market. The short version? It’s the ETFs and Indexes:
The market’s flock-like behavior is one more reflection of the growing influence of investors using broad-based strategies to buy and sell large blocks of stocks. Instead of picking individual stocks to hold over a period of time, they trade in and out of the market using broad indexes. Often, these investors use exchange-traded funds, which trade as easily as a single stock but contain many different stocks that may belong to the S&P 500, the Nasdaq 100 or another index....MORE
Can one make money off this phenomena?
From CXO Advisory:

Stock Synchronicity and Future Returns
Does the degree to which a stock tracks the market and its industry predict its future performance. In their July 2010 paper entitled “R2: Does It Matter for Firm Valuation?”, John Stowe and Xuejing Xing investigate how the coefficient of determination (R-squared statistic) relating individual stock returns to market/industry returns affects the stock’s market valuation and future returns. They calculate R-squared for a stock’s returns using weekly data by firm fiscal year (and apply a logarithmic transformation). Using weekly stock returns and associated firm fundamentals/characteristics for a broad sample of U.S. stocks and weekly market and industry returns (excluding financials and utilities) over the period 1970-2007, they find that:
  • Stocks with higher R-squared relative to market and industry tend to have higher valuations based on accounting fundamentals (Tobin’s q). The average Tobin’s q of the 25% firms with the highest R-squared is 0.25 higher than that of the 25% firms with the lowest R-squared.
  • On average, firms with stocks exhibiting high R-squared are more profitable, larger, older and more liquid than those with stocks exhibiting low R-squared. They also use less debt, have higher institutional ownership and invest more.
  • On average, stocks exhibiting high R-squared underperform in the long run. 22 of 32 equally weighted hedge portfolios constructed annually during 1971-2002 that are long (short) the fourth of stocks with the lowest (highest) R-squared generate positive returns over the next three years (see the chart below).
  • Stocks with low R-squared on average outperform those with high R-squared in seven of the eight years during 1971-2002 for which the stock market has a negative return. During the worst six market years, stocks with low R-squared always beat those with high R-squared....MORE
...In summary, investors may be able to identify stocks inclined to outperform and underperform over the long term based on the degree to which their short-term returns track market and industry returns.