Reading 11, 2.5 Uses of Correlation

2.5 Uses of Correlation Analysis

The CFA text refers to a number of uses for correlation analysis, none of which appears to warrant any further comments.


Two recent articles from the Financial Times & Wall Street Journal did catch my attention.

From the FT:

The recent past has been marked by a high correlation between the performance of stock markets. Indeed the FT reports that the returns have raised to a record during the summer.

 One of the reasons relate to stock indices. Jeffrey Wurgler, finance professor at New York University, reveals in a study how the impact of the simple inclusion of stocks in indices markedly affects their performance so that they move in tandem with other index members irrespective of differences in their earnings or relative valuations.

Some analysts believe that the reasons for assets prices moving more in tandem could be much simpler. One says the increased globalisation of financial markets and interconnectedness of different economies could be a factor.



This theme is also reported on by the Wall Street Journal that states that:

The correlations between stocks and commodities—the extent to which their prices move together—are in many cases the highest they have been in nearly 30 years. Part of the correlation is attributed to algorithmic trading programs. "Algos," automatically buy and sell a wide variety of assets based on mathematical models. An algo doesn't know or care why two assets are moving together; it merely is programmed to recognize that they are doing so. As soon as a computer places bets that such a linkage in prices will persist, other traders—computers and humans alike—tend to take note and follow suit. That can be true, Mr. Simons says, whether or not a correlation is driven by fundamental economic factors.

And the impact of this high correlation on diversification:

For the foreseeable future, there will be plenty of periods in which diversification will seem to fail as tidal waves of money crash in and out of all assets at once. As Mr. Simons puts it, "The longer your time frame as an investor, the greater your risk tolerance has to be now, because over the short term diversification is going to keep looking as if it's disappeared. It will re-emerge with time, though."



Correlation is therefore a concept that is closely watched in the financial markets and form an important part of some trading strategies.


Sources:
1. The rise and rise of correlation, By Anousha Sakoui and Izabella Kaminska, Published: October 6 2010, http://www.ft.com/cms/s/0/5a40b6a8-d176-11df-96d1-00144feabdc0.html##axzz17776B7Un


2. On the Economic Consequences of Index-Linked Investing, Jeffrey Wurgler, Sept 2010, http://www.nber.org/papers/w16376


3. Why Your Stock Portfolio Is Acting Like a Commodity Basket. THE INTELLIGENT INVESTOR, NOVEMBER 20, 2010, By JASON ZWEIG