Wednesday, October 6, 2010

"Trading the correlation bubble"

Smart, very smart.
From FT Alphaville:
Could there be a bubble in correlation?
And by that rationale could it be time to position against a bursting of that bubble?
Those, at least, are the thoughts of JP Morgan’s global equity derivatives and delta one strategy team, led by Marko Kolanovic, in their latest note. It’s rather aptly entitled; “Why we have a correlation bubble”.
(H/T Joe Saluzzi at Themis Trading.)
Here’s their thinking:
1) Correlations between stocks are at their highest levels in recent history.
2) The option-implied price of correlation is even higher — a result of an inadequate supply of index put options and oversupply of stock options via overwriting.
We conclude that both the realized correlation of stock prices and option implied correlation are in a ‘bubble’ regime and forecast a significant decline of correlation over a one- to two-year time horizon.
Increased correlation itself, they say, is down in part to the the macro-driven environment but also (surprise, surprise) to the record use of index derivatives such as futures and also, although to a lesser extent, ETFs and high-frequency trading.
With regards to the index futures and ETF effect, they explain...MORE
We were looking at the opportunity from a different/simpler angle  in July:

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.