One of the biggest themes in the market this year has been the death of stockpicking, as all stocks basically correlate with everything else.
Our colleague Vincent Fernando discussed the idea this weekend, and speculated that stock-picking may be on the verge of a comeback.
That’s also the subject of the latest weekly letter from Raymond James’ Jeff Saut. He connects the dots between market correlation and the failure of market neutral pair-trade strategies, which obviously can’t work when stocks don’t diverge.
I recalled the lyrics “and a partridge in a pear tree” when an institutional account asked me for some “pair trade” ideas. Recall that “pair trading” is considered a market neutral strategy whereby you match a long position in one stock while selling short an equal dollar amount of another stock that is strongly correlated with the long stock position. Then, if the correlation weakens, hopefully your long position rises while your short position falls. For example, from our research universe a pair trade might consist of buying Regal Cinemas (RGC/$12.25/Strong Buy) and selling short an equal dollar amount of Speedway Motorsports (TRK/$14.97/ Underperform). For guidance, I called one of the smartest pair traders I know. His response was, “Don’t do it!” “Why?” I asked. “Because correlations are as high as they have been since 1987,” he replied. Further research reveals that he’s right, for arguably the best pair trading hedge fund in the business is down 11% year to date. Here’s why.
The chart on page 3 shows the correlation of S&P 500 stocks to the S&P 500 Index. Studying the chart one finds that the correlation from September 2009 through early May 2010 ranged between 55 – 65. However, following the May 6th “flash crash” the correlation leaps to ~78 and eventually ~82, which is indeed the highest correlation since the 1987 crash. So what caused this fairly rare event? In my opinion it is because the retail investor – disgusted with high-frequency trading, dark pools, trading huddles, inter-market sweep orders, etc. – simply left the game, leaving the “pros” to trade among themselves. Obviously, when the alleged “dumb money” left the party correlation had to rise. Adding to the situation has been Exchange-Traded Funds (ETFs). To wit, when volume increases in say the Powershares Consumer Discretionary ETF (PEZ/$21.08), that ETF automatically goes in and buys ALL 60 of the mid-cap stocks within the fund. Plainly, that causes correlation to rise.
The conclusion from my brief study is that pair trades are not working. Consequently, to make money you must take only one side of a position, either long or short. A potential insight is that as correlation recedes it might imply retail investors are returning to the equity markets. Currently, however, this is not the case, for as repeatedly stated, “I have not seen retail investors so unwilling to discuss stocks since the fourth quarter of 1974.” That gleaning is reflected by the sentiment figures and the money flows out of equity mutual funds. With such a dour mindset, I think “Something’s Gotta Give.” That belief is driven by the fact that corporate profits continue to explode. Indeed, with 99% of the S&P 500 (SPX/1109.55) companies reporting, operating earnings for 2Q10 have increased roughly 52% year-over-year to $21. Ladies and gentlemen, the peak in quarterly earnings tagged $24.06 a few years ago. Hence, we are roughly $3 away from bettering all-time peak earnings! Currently, this year’s earnings estimates for the SPX are hovering around $83, while next year’s are sticky around $95. The question then becomes, “What price-to-earnings multiple will Mr. Market put on said earnings if those estimates prove accurate?”
Here’s the chart he’s referring to:
The whole thing is a must-read, so we’ve embedded it here.