You may have heard that the Dow hit 13,000 today before subsiding to a shameful 12,965.69. You may not have heard this, or cared, because the Dow is for morons, being a price-weighted index of thirty semi-random companies that, gah, aren’t even “industrial” any more.** There are alternative theories but those theories are wrong:
Joe Weisenthal in defense of the Dow has been noting its very high correlation with other, broader, more sensible indexes. I see this as further undermining the Dow’s legitimacy. If it’s very different methodology were leading to some kind of meaningfully different result, then we could perhaps argue that it’s adding value in some kind of way. But instead what’s going on is that the Dow’s creators are hand-picking which stocks to include in the index specifically with an eye toward constructing an index that mirrors the other, better indexes out there. Apple and Google, for example, aren’t in the Dow and aren’t doing to get in any time soon because their very high share prices would skew the index in weird ways. This just goes to show that the Dow’s creators already “know” the right answer (from looking at the S&P 500 and the Wilshire 5000) and then are trying to assemble an index to create the predetermined result.
Maybe! An alternative theory is maybe suggested by [Occam's razor and] this piece from the Journal this weekend about index funds that I just loved and so am now going to inflict on you at unnecessary length: Continue reading »
Goldman Sachs has a piece of research out today on ETFs, billed as sort of “ETFs for dummy portfolio managers who need to start understanding them.” It’s worth a read if you can get it, with a decent overview of questions that it is probably possible to think too hard about, like whether 400% short interest in many big ETFs is worth freaking out about (short answer: nah).
Particularly useful is a cautious but intelligent stab at the question of whether increased correlations are being driven by increased ETF use:
A substantial debate exists among investors about the cause of increased correlation. Namely, are correlations high simply because the environment is dominated by the macro? Or, are they due to the increasing use of index-level products, such as ETFs and futures? And most importantly, how do these forces interact? Given the nature of the cause-and-effect relationship of the two sides of this debate, we find our highest value in becoming more granular in our approach to these questions by specifically focusing our work on sector-based observations rather than index-level ones.
For those who like charts, here are two charts: Continue reading »
If you read only one thing about ancient fire management methods and modern volatility, it should be this report by Chris Cole of Artemis Capital Management.
There is much goodness here that others have discussed. But perhaps the most interesting for the current world is the move from positive to negative serial correlation in stock prices over time. (Positive serial correlation means that stocks are more likely to go up the day after an up day, negative that they’re more likely to go down on the day after an up day, and zero that yesterday’s performance is not predictive of today’s.) Serial correlation peaked in 1971, floated around zero-ish from 1980 to 2000, and is now strikingly negative:
As Cole says: Continue reading »
Correlations between and among asset classes tend to go way up in periods of stress, and so it should come as no surprise that Biblical events have, um, correlated with record correlations among stocks. Here’s the chart from Goldman’s David Kostin:
Really high correlations make trading really easy! All you have to do is get the right direction, then it doesn’t matter what stocks you pick. So how’d everyone do?
Not so great. The Wall Street Journal talked to Credit Suisse:
Based on one-month trailing movements, S&P 500-index stocks have a correlation of 80%, even higher than the 73% peak reached during the crisis in late 2008, says Ana Avramovic of Credit Suisse.
The impact is felt by everyone from small investors to the most sophisticated hedge-fund managers, who often go long and short different stocks rather than bet on market direction. Indeed, Ms. Avramovic points out that hedge funds tend to perform better when correlation declines and suffer when it increases.
CNBC, on the other hand, has been reading Goldman’s Kostin, whose own headline is “Hedge funds outperform in correlated sell-off.” He explains:
Continue reading »
Zero Hedge points out this awesome chart in an otherwise kind of back-test-eriffic Stanford paper on credit-equity correlation trading:
The chart graphs 2003-2010 investment grade credit spreads (left axis) versus the S&P (bottom axis), with the size of the circles corresponding to the level of the VIX volatility index and the colors distinguishing the year of the observations.
Continue reading »
