strong correlation

Recently, the 250 largest stocks in the S&P 500 have been marching up and down in formation with one another 80% of the time.  This compares with 30% of the time in normal circumstances, according to a Financial Times report of a study by JP Morgan.

That correlation is higher than during last year’s “flash crash,” when a hapless midwestern portfolio manager ordered his trading room to sell massive amounts of stock index futures without regard to price.   It’s also higher than at the market bottoms in 2003 and 2009.  In fact, the lockstep movement of the biggest S&P names is at its highest since Black Monday in October 1987, a time of immense panic as an unprepared investing world witnessed for the first time the power of stock index futures to move equity prices.

What’s going on?

As the 30% number above indicates, most of the time investors in the American stock markets trade to rearrange their holdings as new information about individual companies emerges.  We sell stocks we think are overvalued and reinvest the proceeds in stocks we think are undervalued.  We also respond to changes in the overall economic environment by buying economically sensitive issues and selling defensive ones, or vice versa.  We typically don’t try to time the market by raising cash.

The movements analyzed by JP Morgan are different.  They represent asset allocation shifts into stocks (and away from cash and bonds) or away from them (and into fixed income)–rather than rearranging the “cards” in the hand the portfolio manager is playing.

Two–maybe three–points:

1.  US stock portfolio managers don’t act this way.  Yes, almost everyone is able to sell stock index futures against stock positions earmarked for sale, in order to raise cash more quickly.  But the few people who actually do this are too small to create the effect we’re seeing.

2.  The selling we’re seeing is more characteristic of EU-based managers, who tend to manage balanced portfolios (i.e., portfolios that contain both stocks and bonds) and to use top-down asset allocation techniques to decide what they hold.

In addition, if there’s going to be a recession any time soon it’s going to be in the EU, so EU manager selling would make some sense.  Trading-oriented hedge funds may be taking the other side of the transactions.

3.  More important, this behavior is typically a sign of very strong emotion–mostly fear.  In my experience,  a high level of panic is so psychologically exhausting that it can’t be sustained for a long time.  Also, it typically only occurs at significant turning points in the market.  Normally at least a “relief” rally follows.

I don’t expect a big rally this time, however.  To the degree that the current sellers are reallocating assets they own, rather than speculating on the future course of markets, they’ll eventually run out of stuff to sell (or recover their equilibrium) and their influence on the S&P will gradually fade away.  I think a sideways market, where stock pickers rule, will emerge.

I’m often too early, but I’m starting to see hints in the past few days that this is already starting to happen.