Oct

17

philThe volatility of the market has dramatically increased in the last few weeks. It is often said that the correlations between various markets increase at such times due to forced margin selling. Certainly such a suggestion is plausible on its face but like everything else must be tested.

One can look at the same-day correlations between various macro variables and the S&P. For this purpose the relevant ETFs were chosen. The correlations with SPY are as follows:

Oil                81%
Gold            -32
Tbonds        -53
Tbill             -53
Yen             -64
UK stocks     93
Japan stocks    93
VIX               -86

The most striking is the strong positive correlation with oil. One interpretation is that oil is driven by recession fears just as stocks are. Another explanation may be that oil is being liquidated to finance stock margin accounts just as the pundits claim. Clearly holding oil is not now a hedge against a stock portfolio.

But when we look at gold the correlation is negative. This would tend to serve as evidence against a wholesale correlation of assets being sold. To some extent gold is still a hedge against a stock portfolio. The same goes for treasury paper and the yen. But we do see UK and Japanese stocks being strongly positively correlated. So it appears that many world markets are strongly correlated with each other. Again this may be a sign of coordinated margin liquidation. The strong negative VIX correlation can be interpreted as the markets are now being strongly driven by fear. None of this is predictive but is an interesting descriptive look at where we are now.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008


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3 Comments so far

  1. Anton Allostrat on October 17, 2008 12:22 pm

    The dangers of using historic correlation during a deleveraging environment can be seen in a global asset allocation portfolio. I invest a portion of retirement assets in a twenty-four component portfolio that is internally weighted for an expected annual 10% return at 8% standard deviation. Recently many of the portfolio components have become highly correlated, most strikingly during the two-weeks ending Oct. 14. At one point, the sum of intra-portfolio correlations, using 60-days data, spiked to 42% with a 31% standard deviation. However, even in short restricted account there is a solution. With the advent of short ETFs, simply establish an effective short position, (SDS for this example, which has a negative 51.5% intra-portfolio correlation) at a level calculated to bring the sum of intra-portfolio correlations into the desired range (in this case + or – 6%). This short position brings expected returns and volatility back in line with model expectations. Be prepared to adjust frequently though, as relationships are beginning to return to a more normal

  2. David Whitesel on October 18, 2008 8:43 am

    anything normal about this trend.

    3 consecutive trade days data for 3 years……

    date….#of Companies….Total Vol…Block Vol…Totl Trades
    block trades
    2008

    19-Sep 3200 4,065,219,165 496,162,633 13,022,420 14,344
    18-Sep 3199 3,990,786,026 438,886,083 15,563,948 13,012
    17-Sep 3194 3,240,667,427 443,570,648 12,782,761 10,874

    2007
    19-Sep 3,281 2,234,189,510 329,894,832 7,175,239 10,734
    18-Sep 3,281 2,157,640,265 314,998,802 6,981,634 10,109
    17-Sep 3,284 1,561,091,236 314,127,024 4,732,082 7,799

    2006

    20-Sep 3344 2,253,390,918 349,210,437 5,573,322 15,464
    19-Sep 3334 2,160,872,017 389,412,160 5,748,431 13,849
    18-Sep 3336 1,980,975,019 464,671,481 4,851,228 11,448

  3. Matt Johnson on October 18, 2008 2:48 pm

    Can you please tell me how a speculator uses this information. It seems like a bunch of fluff, but I don’t have a PhD…

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