Watching the market action over the last few months, I am reminded of the traditional circus of my youth. When the Ringling Brothers rolled into Madison Square Garden, the elephants would march in at the beginning of the show. Each elephant would hold the tail of the elephant in front with his or her trunk and they would parade around the main ring. When the ringmaster raised his hands, the elephants would lift their trunks, and consequently, the tails of the elephant in front. When the ringmaster lowered his hands, the trunks went down. Around and around it would go until the elephants found their places and started lifting clowns and circus girls into the air with their now unoccupied trunks.

Obviously the ponderous elephants today are the financial markets around the globe which have risen only after dramatic flourishes by the ringmasters (Central Bank worthies and European politicians). However, when these ringmasters let their arms down to prepare for the next flourish, the elephants have been dropping their trunks around the world. Without the ringmaster, market participants are not willing to step out of line and risk capital (note the repeated approaches to but few breaches of the 200 day moving average on the SPX). And this observation is not just a reminiscence of youth. Thanks to Bloomberg, it is not hard to plot the increasingly correlated nature of the main equity indices.

Correlations between the equities markets are tightening

Data Source: Bloomberg

I constructed this chart by taking the weekly correlation measurements at monthly intervals. At the far left it measures the correlation for 12 months (Dec 15 2010 – Dec 15 2011). The next point is from Jan 15 2011 – Dec 15 2011 (11 months) and so on until the last data point on the right which measures just the past month. The function on Bloomberg is CORR for the Correlation Matrix.

What do I think this means?

Although this is a non-standard “study” of the market, I think it demonstrates pretty clearly how dramatically the nature of the markets have changed over the year. What surprised me the most was how much GLD’s relationship with the SPX has shifted (much to the chagrin of gold bugs with 2000 price targets). I also looked at TLT as a proxy for treasuries and its correlation moved from -0.79 to -0.87 through the same period. I suspect that the “dead hand” of policy risk (both political and monetary) has stamped down the risk appetite amongst investors for any significant investment time horizon.

I think there are two key take-aways from these “observations”.

First, we need to watch for opportunities to sell puts and calls when the VIX is high because there are not the usual amount of “asset allocation” opportunities to make money. With little divergence to play for and markets that appear range bound in the medium term, clipping options premiums may not be a bad way to pass the time.

Second, we need to watch for the divergence. Although I have not done an exhaustive study, it makes sense that market convergence and divergence would happen in waves. As we saw in the 2008/9 period, the high correlation into the meltdown was matched by a divergence once the markets started to rally off the bottom. If history is any guide, a shift towards more divergence should spell the end of the current slog. At that point, we should see winners and losers emerging and asset class breakouts (hopefully to the upside). It will be a concurrent indicator at best but with the current lack of confidence, that may be a useful confirmation of a change in trend.

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Filed under: Investment IdeasMarket PsychologyMarket Theory

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