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At what turned out to be the top in April 2010, I wrote Technical Reasons for More Stock Market Gains. Like many other technical analysts, I was relying on breadth indicators like the cumulative advance decline line and new highs vs. new lows and was caught flat-footed.
Since then, I’ve been wondering why such reliable indicators suddenly betrayed us. One clue may lie in the fact that right now we have a stock market, not a market of stocks. According to a study by Birinyi Associates, the correlation of S&P 500 component stocks is at historic highs:
Source: The Herding Instinct Takes Over (WSJ)
According to Birinyi, the average correlation since 1980 has been 44% - in comparison, it is 81% right now. The previous high was 79% in late 2008 and the all time high is 83% claimed by the infamous 1987 market. There is also another spike in correlation above 60% in 1998 and again in late 2002. So it is self evident that there is a link to volatility. Apparently, when there is fear, traders and investors treat the stock market as a homogeneous entity rather than a composition of varying individual stocks. And looking back at more than 60 years of data, we can see that we are experiencing a very volatile market right now. Of course, you already knew that intuitively.
I’m sure that the growth of basket trading followed by the slicing and dicing of the market into ETFs has also contributed to this pattern. But since there is an ebb and flow to the correlation over time, instead of a steady, unrelenting trend, I think it reflects mood more than an underlying structural change in the market’s functioning. Another reason is that even stable dividend paying stocks like Microsoft (MSFT) get bought and sold with equal frequency as other lesser quality stocks.
The challenge however is that once individual components start to go in lock-step, the many traditional indicators that look at market internals suddenly become much less useful. They can be dangerously quiet when we need them the most.
For example, the historically observed pattern for the new highs and new lows measure has been that it tops out weeks and months ahead of the actual index, giving us a heads up with ample time to prepare. The same is true for the AD line. But in April, they both topped out concomitantly with the S&P 500 index.
For more on this, see this morning’s notes which has a chart of sector correlations.
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