Highly Correlated

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Good morning. Perhaps the story of the year in the stock market isn't about the trouble in the Middle East, the triple tragedy in Japan, or even the European sovereign debt crisis. Understand that I'm not talking about market-moving stories because obviously Europe has been the driving factor for much of the past 18 months. No, I'm referring to the way the market has been moving. Dubbed a "risk on/risk off" environment, the big story is the record level of correlations between stocks as well as asset classes to the S&P 500.

As I have detailed over the past couple of weeks in this column, lots of indicators and management strategies have fallen on their faces this year. I'm of the opinion that the risk on/off environment is to blame here as markets of all colors, shapes and sizes have tended to move in the same direction as the U.S. stock market lately. Or perhaps put more accurately, the German DAX index. The bottom line is that unless you hold U.S. government bonds, almost everything else has acted like the stock market.

If you don't believe me, take a peek at the following charts over the past six months or so: SPY (the U.S. stock market), EFA (EAFE index - Europe, Australia, and Far East), EEM (emerging markets), ILF (Latin America), IYR (Real Estate), and the DBC (Commodity index). See what I mean? It hasn't mattered if you invested in the U.S., overseas, emerging markets, real estate, or even commodities - they've all moved in approximately the same direction at approximately the same time.

So, if you happen to be one of the legions of investors that put their faith in the diversification called for by modern portfolio theory, you now find yourself with a portfolio consisting of six buckets of white paint and U.S. Government bonds (which, by the way, may be the most overvalued asset class on the planet). And as such, you are probably ready to tear your hair out right about now.

Stock pickers are facing a similar fate at the present time as most stocks are simply acting like the S&P 500. The phenomenon of high corrleations is generally associated with a market crash or other very swift declines during which, all stocks tend to go the same direction. For example, during the Crash of '87, more than 80% of all stocks were correlated exactly with the S&P 500. Given the severity and the brevity of that decline, the high correlation certainly makes sense.

However, after 1987, the rolling correlation of stocks to the S&P 500 (we're using a median 63-day rolling correlation of 1-day returns here), rarely exceeded 60%. Well, until 2008 that is.

While I'm merely eye-balling the chart of correlations here, since 2008, the average correlation of stocks to the S&P 500 index looks to have averaged more than 70%. And the recent reading of nearly 85% was an all-time record. If we take a longer-term view and look at the rolling 6-month correlations of stocks to the S&P, the current reading of 82% is also a record. As is the 76% level seen in the rolling 1-year correlations.

In other words, this market isn't about "selection" or diversification. No, it's all about the timing of putting risk on and taking it off in the stock market. In the old days - before the mutual fund industry convinced everyone on the planet that buy-and-hope was the answer - the timing of buying and selling was all the rage. Take a look at a weekly chart of the stock market from 1965 through 1982 and you'll understand why. And don't look now fans, but it appears that the 1965-82 type of sideways market is back.

The exceptionally high level of correlation to the S&P is also impacting a boatload of tried-and-true momentum indicators. Two of my favorite "thrust" indicators have been excellent buy signals over the years. In the past, when the market has made a concerted move up in a short period of time, stocks have tended to keep moving higher for a year or so. For example, if you look at the ratio of advances versus declines over a 10-day period, buying when the ratio was over 1.9 has been money in the bank. And the great thing about this indicator is it didn't occur very often. From mid-1947 through 2007, there were only 28 signals. However, due to all of the one-way moves we've seen in the market lately, there have been 8 of these signals in the last two years alone. Thus, it is hard to know whether you can trust many of these indicators anymore.

So, will the highly-correlated market environment continue? My guess is that as long as the market remains fixated on every word out of every European leader's mouth, the answer is yes.

Turning to this morning... Although the talk of the IMF providing loans to Italy has been denied, reports that Eurozone leaders are working on creating a Stability Union and have finally come up with rules for leveraging the EFSF has caused shorts to run for cover and buyers to emerge. In short, the markets seem to like what it hears. Risk on.

On the Economic Front... We'll get a report on New Home Sales at 10:00 am eastern.

Thought for the day... Do you think to say "thank you" for the good things that happen each day?

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

• Major Foreign Markets:
  • Australia: +1.68%
    
  • Shanghai: +0.12%
    
  • Hong Kong: +1.97%
    
  • Japan: +1.56%
    
  • France: +4.04%
    
  • Germany: +3.60%
    
  • Italy: +3.68%
    
  • Spain: +3.53%
    
  • London: +2.34%
  
  
• Crude Oil Futures: +$2.82 to $99.59
  
• Gold: +$31.50 to $1717.20
  
• Dollar: lower against the Yen, Euro and Pound
  
• 10-Year Bond Yield: Currently trading at 2.073%
  
• Stock Futures Ahead of Open in U.S. (relative to fair value):
  • S&P 500: -29.63
    
  • Dow Jones Industrial Average: +232
    
  • NASDAQ Composite: +52.89

 

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The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion