Market Highly Correlated? That Depends.
Today started out pretty well on Wall Street, only to have an airport shooting incident in Germany make the rally turn on a dime. Buyers returned once it was clear another 9/11 wasn’t unfolding.
More important in the big picture was Ben Bernanke’s testimony on Capitol Hill. When he was asked what conditions would warrant a third round of quantitative easing, Bernanke replied that “what we’d like to see is a sustainable recovery. We don’t want to see the economy falling back into a double dip or to a stall-out.”
Of course, everyone would like to see a “sustainable recovery” and no one wants to see a “double dip.” That’s not the point. Bernanke did not categorically rule out the idea of a QE3 program, nor did he even sound hesitant. U.S. monetary rhetoric is beginning to diverge from Europe and Asia, where there is great concern for inflation. Changing rhetoric is not the same as changing policy, but it is a step in that direction. The bottom line is that the Fed is not planning to tighten any time soon, and oil is now over $100. Gold hit a new high before retreating a bit.
Our three Edge charts, as we will elaborate below, currently show three dramatically different views of the market. Among sectors, we have one very clear leader (Energy) and everything else. All sectors have positive momentum. The Style categories are all solidly and nearly equal in their bullish alignment. Globally, we have some regions positive and others negative, with every category showing a different degree of momentum.
How do we interpret this? Currently, correlation between sectors is very low, while correlation between styles is high. Financial pundits sometimes talk about how everything in the financial markets is now connected and correlation is very high. Our response: It depends how you look at it. Anyone who has been in Energy stocks recently is probably pleased. Those holding China stocks, not so much.
Energy further separated itself from all other sectors this week. A quick glance at our Sector Edge chart leaves no doubt who is in the lead. There is Energy – and then there is everything else. Among the others, there is some differentiation. Higher fuel prices hit the transports hard, punishing the Industrial sector of which transportation is a part, but Industrials still kept the second-place position. The four-way tie for third place has broken up a bit but still contains the same four sectors: Consumer Discretionary, Materials, Financials, and Technology. Telecom slipped into last place, while Utilities is showing some resilience amidst the turmoil.
The Style rankings are now extremely compressed with all eleven categories showing momentum readings in the 20s. The stack is still mostly inverted by size, with Small Growth on top and Mega Cap on the bottom. It would not take much for any group to move way up or way down, relatively speaking. What would generate such a move is unclear, given that the Style categories seem to be increasingly correlated lately.
Canada maintained its grip on the top spot, thanks to the Energy sector’s strong outperformance. Japan pushed aside the U.S. to take second place, helped by a stronger Yen. The Euro was strong, too, allowing even once-moribund Europe to move ahead of the U.S. The overall pattern of the last month, with developed markets all positive and emerging markets all negative, is still in place. China, though still on the bottom, was one of the few categories to show improvement from last week. This may be the first hint of a trend change.
The charts above depict both the relative strength and absolute strength of various market sectors, styles, and geographic locations on an intermediate-term basis. Each grouping is sorted (top to bottom) by relative strength. The magnitude of the displayed RSM value is a measure of absolute strength, which is our proprietary method of measuring and reporting the intermediate-term strength as an annualized value.
“The only thing that goes up in a down market is correlation.”
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