The average correlation between SPY and its main sector etf's (xle, xlf, xlk, xlp, xly, xli, xlb, xlv) has been very high recently. I wanted to see how volatility tracks with correlation (correlations go to 1 in a panic). I regressed the 60-day volatility of SPY on the average 60-day correlation between SPY and the sector etf's from Sep 2005.

sectorCor = .77 + .04*spyStd
spyStd t-stat 19

Then I updated the regression for 2010 and found
sectorCor = .78 + .10*spyStd
spyStd t-stat 38

Any thoughts on the rising correlations or the relationship to volatility levels?

Vince Fulco comments:

Ex. the most recent vol decline, which we'll see how long it lasts, it is my contention that as spreads have come down, for quite some time, the Street have been manufacturers of vol & opacity in new fangled products and facilitators of fake 'information' for its own sake. What kind of system allows for the trading of 300MM shares of C with a penny spread and the rebate boys still go home big winners? Leveraged and branded ETFs provide more vig for dealers to trade within and sucks in the naive who can't or won't trade the futs space and don't understand the derivatives underlying the products. As we've seen time and again, liquidity which everyone seems to expect and demand esp. when it disappears, would seem to be the defining issue as increasing correlations demolish old theories of portfolio creation. Lack of diversity would seem to badly endanger the system as it does in nature. Perhaps I will be wrong if the tail sellers in this phase overwhelm the vol creators…Or maybe both sides win with enough switches. 

George Zachar agrees:

I agree with what you said about how lack of diversity would seem to badly endanger the system as it does in nature. The investing monoculture gives the illusion of stability and reason, while in fact offering a brittle alogical ecosystem.Street research now is heavily biased toward encouraging carry whoring, which is of course vol selling. 

Gary Rogan comments:

This is also an indication that those who attempt to trade on the fundamentals have exited the building. It's not clear exactly why, but my guess is it's a combination of the lack of trust in any published accounting data related to the out-in-the-open distortions in the financials' balance sheets, the uncertainty about the future and what the fundamentals imply about the future, and the self-reinforcing relative rise in the volumes due to algorithmic trading. When the robots trade based on the algorithms that evolved in the presence of fundamental investors after they are no longer there, sooner or later the results will resemble what would happen to the surface of the earth if gravity were to suddenly disappear. 

Rocky Humbert writes:

Gary: I would be interested in your basis for making this case. One could argue that it was in the late 1990's when those who invest on fundamentals were forced to leave the building. Unlike Elvis, we've now re-entered.

Intel at 11x earnings (now) makes more sense than at 70x earnings. (then). Pfizer at 10x earnings (now) makes more sense than at 55x earning (then). Coke at 14x (now) versus 50x (then) … Internet stocks etc etc …

Gary Rogan responds: 

Rocky, first of all we are talking about slightly different time frames. Certainly the late '90s were a unique period when even the most stubborn fundamentalists had their believes tested I'm talking more of what transpire say between 2003 and 2007, after the "buy on the dips" fully died down and before the full force of the credit crunch was appreciated vs. today. While I don't have a scientific basis for this, what I wrote was based on reading literally hundreds if not thousands of comments on financial blogs, some serious, where the writers expressed disgust at the market reaction to (a) some piece of negative macro news (b) another "stress test" (c) another major bank's quarterly release claiming a great rise in profits immediately deconstructed on that same blog to be (supposedly) completely fake. So many claimed to have given up looking at the fundamentals and expressed so much suspicion, I thought that perhaps there IS something to what they are writing and it's not all a conspiracy to confuse someone. I have also read several articles about the relative rise of machine-generated volume vs. retail investors, as well as the reasons for the market rise in the presence of mutual fund outflows.

I'm not sure that P/E compression by itself signifies trading on the fundamentals. Certainly SOMEBODY does when that happens, like our good friend the sage in the early/mid '70s doing his "oversexed guy in a harem" impersonation. But overall I think it's more indicative of the lack of confidence. I guess what I was referring to is some "typical" market where momentum traders are driving various stock and sectors in all kinds of directions (but not as far as the in the '90s) and some Gabelli-like or Lynch-like character gleefully commenting on the kind of opportunities those idiots gave them in the value space. I'm not sure some space cowboys riding C and BAC like wild mustangs on unbelievable volumes quite gets you there.

Here is more on asset correlations and intraday patterns:

By now, after Zero Hedge has been demonstrating for about a year, even the kitchen sink is aware that cross-asset correlations between stocks, bonds, FX, and commodities is at or near all time highs, which in itself is a very deplorable situation simply because it eliminates virtually all long/short hedging opportunities, courtesy of the Synthetic CDO redux boom whereby most of the trading in stock is conducted via ETFs, as both high beta and low beta, or quality and crap assets all trade as one. But few if anyone was aware of peculiar intraday correlation patterns which may be an eye opener to some readers who believe that stocks are uniformly broken during the day. That is not true: in fact, stocks are only untradeable for the rational investor during the times when the market is most active, around open and close. In fact, in a paper by Michael Bommarito II, "Intraday Correlation Patterns Between the S&P 500 and Sector Indices", we discover that average return correlations have a very distinct U-shape, whereby correlations are near their highs (0.75) just after the open, and before close, while dropping to a statistically significant 0.6 at 1 pm, when volume is the lowest. This merely confirms that increasingly more market participants, read - electronic traders and algos, trade exactly the same strategies at the time when volume is at its peak, indicating that most strategies have nothing to do with actual fundamental investing and all to do with gaming market structure, and hoping to capture some idiot who thinks they can beat the machine. And as we demonstrated recently, many traders no longer trade during the hours between 10am and 3pm. Which means that this is actually a very interesting arb opportunity, for those who wish to take advantage of the machines' downtime, but shorting correlation at open and close, and bidding it up during the day. In fact the trade can be structured as a pair trade with almost no capital downside opportunity.



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