Saturday, September 11, 2010

What Is High Implied Correlation Telling Us

(HT to zerohedge for chart) Anyone who has traded the past and current markets activelyknows about correlations. The S&P500 following the movements of the US dollar and equities inverse relationship or the relationship between crude oil and US dollar are two simple examples of historic asset correlations. NOT historic, NFLX/SPX or now Citi is the market.

Over the past thirty years stock correlations have been a natural phenomenon with about 30% of stocks exhibiting correlation, though as you can see represented above implied correlations have been on the rise since 1998. What is interesting about this date?

Well nothing, though this is near the time where electronic trading and ETF's were becoming more prevalent. From July of 1998 correlations rose as the .com bubble, real estate bubble came and went. Two big piles of shit wall street swept under the rug by via low interest rates and the secularization of "things". Basic life support mechanisms implemented to buy time before the whole interconnected mis priced house of cards collapses.

As of today we are sitting near 100% correlation, the entire stock market is one big giant asset. The S&P500 you could say is the core asset with insane gravity which affects the prices of every single stock in the market, including the other 3k+ stocks no in the S&P500. As zerohedge pointed out, there is no way to price the assets when everything is moving in tandem, you need divergence. When assets diverge and QUICKLY seek their true value, things will get wild. IF you look at this chart, you will see before the market crashed in fall 2008 the S&P500 correlation was over 80% then the market crashed.

We are quickly approaching those levels once again. Currently 75% AVERAGE. This number is much higher when you take into account all the other stocks no in the index all trading hand and hand with each other. No reason why a speculative bio tech stock should track the S&P500 tick for tick, the market is driven by unmanned machines who increasingly have no idea what to do. All because the human element began leaving the market in 1998. Solution?

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