Correlation, Numbers Etc

Thursday was an eventful day for me. I actually read a study reported in the Bloomberg and for a change found it worth reading and at the same time something which made sense. Hence, despite the fact that it was reported in Bloomberg, I have sent it to you as an attachment just in case you have, like me, given up reading news/studies or market commentaries and taken to staring at the TV with the audio cut off. For a while now, we have all, perhaps, been perceiving an increased correlation among stocks and even among various asset classes. This study actually highlights the reason and is worth reading.

Now that I know that stocks are highly correlated at times of high political uncertainty and since I can also trust that this political uncertainty will persist for a long time and finally since political pronouncements are inherently difficult to predict, I can now offer an intellectual justification for my refusal to make an effort to study various companies and their performances and my refusal to stock pick and finally for my insistence on simply trading the Nifty instead of the various stocks within it.

Thursday has been also extremely eventful for the fantastic Test Match between Australia and South Africa. But what stood out was the peerless century by Michael Clarke in the Australian first innings. On its own 150 is not such a big score for a batsman. His effort is however, made incredible by the fact that South Africa got out for 96 and then Australia themselves were shot out for 47 in the next two innings which together is less than what he as an individual scored. Surely a feat that secures him a place in the pantheon of the greats of the game.

However,a future fan, when he peruses the statistics and data, will never be able to appreciate the incredible beauty and incandescence of this innings of Clarke. If only, there was a way to collect data in a way that comparisons are made more meaningful. A way for numbers to speak and reveal the complete story. A way for a future cricketing fan to know that it was this innings that turned a precocious talent into a batsman to be respected and feared. A way for the future generation to know that irrespective of what average Clarke ends up with, for one day at least, he dwarfed the best of the cricketing world and strode the world stage like a colossus.

Similarly, I wish there was a way to make the reported numbers of companies more meaningful. I wish that the truth of those numbers were made more obvious or transparent and did not have to be gleaned by perusing through various fine prints in thick company balance sheets and from various filings with regulatory bodies. I wish that painstaking analysis was not a prerequisite in order to be able to meaningfully compare numbers of companies even within the same sector.

But as they say if wishes were horses then..... So we all make do with what we have. Since I do not like what we have currently, I dispense with it all together. I therefore trade based only on price information and not based on any fundamental reported numbers.

I am currently flat on the market. Will short today 50% of my exposure if Nifty trades below the first hours low. Might even short 100% sometime during the day. Will keep you posted.

The STUDY that I wrote about if you are interested

When Markets Are Hostage to Political Flux: Pastor and Veronesi

2011-11-10 00:00:30.0 GMT

By Lubos Pastor and Pietro Veronesi

    Nov. 10 (Bloomberg) -- Politics are dominating financial

markets. Day after day, prices react to news about what

governments around the world have done or might do.

    The markets were jubilant two weeks ago when European

politicians announced a deal cutting Greece’s debt in half. U.S.

stocks soared 3.4 percent on Oct. 27, while French and German

stocks gained more than 5 percent. Early last week, equities

gave back those gains when Greece’s prime minister, George

Papandreou, announced his intention to hold a referendum on the

bailout. When other Greek politicians voiced their opposition to

that initiative, markets rejoiced again.

    It is stunning that the pronouncements of politicians from

a country whose gross domestic product is smaller than that of

Michigan can instantly create or destroy hundreds of billions of

dollars of market value around the world.

    Yet, despite its obvious importance, political uncertainty

is notably absent from mainstream finance theory. Indeed, it

would be a waste of time to search financial textbooks for

models that take into account uncertainty about future

government actions.

    In a recent paper, we tried to fill this void by developing

a simple model of financial markets in which the government has

the option to intervene. Since the officials’ political motives

are somewhat unpredictable, investors cannot fully anticipate

what a government is likely to do.

    How do governments affect stock prices? Our model

highlights two opposing effects.

                       ‘Greenspan Put’

    On the one hand, by intervening in times of trouble,

governments effectively provide put protection to stock

investors. A famous example from monetary policy is the

“Greenspan put,” denoting aggressive interest-rate cuts in

response to adverse economic shocks. This implicit put

protection makes stocks more valuable by essentially laying a

floor under equity prices.

    On the other hand, since government policy decisions affect

companies across the board, investors can’t eliminate the risk

associated with these decisions by holding a diversified

portfolio of stocks. Non-diversifiable political risk makes

stocks less valuable by raising discount rates that investors

apply to future cash flows of companies.

    In short, in times of trouble, we expect governments to

step in, but we can’t predict exactly what they will do. Which

of the two forces will prevail -- put protection or risk -- is

unclear.

    Our model makes a number of predictions. We should see more

government interventions when the economy is weak. Political

uncertainty should lift risk premiums and make stocks more

volatile and more highly correlated. Political news --

indications of what governments might do -- should affect stock

prices, especially in weak economic conditions. In strong

conditions, prices should respond mostly to fundamental economic

shocks. These predictions appear consistent with recent events.

    One of our central predictions is that political

uncertainty should make stocks more correlated, or more likely

to move together.

    To see how this holds up in the data, we measure political

uncertainty using the policy uncertainty index constructed in a

recent paper by Scott R. Baker and Nicholas Bloom of Stanford

University and our colleague Steven J. Davis of the University

of Chicago Booth School. This index combines three types of

information: the frequency of media mentions of policy

uncertainty; the number of tax provisions expiring soon; and the

extent of disagreement among forecasters of inflation and

government spending. The authors described their index in this

column last month.

                       Stock Correlation

    To measure stock correlation, we compute the market-

capitalization-weighted average of the correlations between all

pairs of stocks that constitute the Standard & Poor’s 500 Index.

We calculate this value monthly from daily returns and smooth it

by taking the three-month moving average.

    The attached chart shows a strong association between

correlation and political uncertainty over the past decade.

    Clearly, stocks are more likely to co-move when political

uncertainty is high, as the model predicts.

    Our chart runs through December 2010, but the positive

association between correlation and uncertainty continues in

2011. The policy uncertainty index reached record levels during

the debt-ceiling dispute this summer. In early September,

JPMorgan Chase & Co. reported that the average correlation

between the biggest 250 stocks in the S&P 500 Index reached 81

percent, the highest level since 1987. Last week, the CBOE S&P

500 Implied Correlation Index reached 83 percent, twice the

level of four years earlier.

    The high stock correlations have made life difficult for

fund managers. The ability to pick one stock over another isn’t

worth much when all stocks move together.

    The high correlations also make it difficult for investors

to diversify. The old advice that holding 15 to 20 stocks is

enough to achieve diversification is clearly out the window.

Even holding many more stocks falls short when stock co-movement

is almost perfect.

    To make matters worse, stocks tend to be more correlated

when markets are more volatile. Diversification fails when you

need it most.

    Given the limited diversification opportunities in the

stock market, many investors have turned to havens such as gold

and Treasuries. This strategy has a cost, though: Gold pays no

dividends and the 10-year Treasury yield of about 2 percent

pales in comparison with the 3.9 percent rate of inflation over

the past year. Both gold and Treasuries have appreciated in

recent years, but further capital gains are anything but

guaranteed.

    If we could wave a magic wand and make political

uncertainty disappear, risk premiums, volatilities and

correlations would all subside. Stock prices would rise.

Companies would be more willing to raise capital and expand

hiring. People would have more money to spend. The dormant cogs

of our economy would begin moving again.

    Unfortunately, political headlines are unlikely to go away

anytime soon. The European crisis is far from over, and the

wrangling over taxes and budget cuts in the U.S. is bound to

continue. As long as politicians keep us in suspense, businesses

will hold back and investors will keep on struggling to

diversify. Gold, anyone?

    (Lubos Pastor and Pietro Veronesi are professors of finance

at the University of Chicago Booth School of Business, and are

contributors to Business Class. The opinions expressed are their

own.)

For Related News and Information:

More Bloomberg View: VIEW

Developed Markets View: DMMV

World stock indexes: WEI

Most-active U.S. stocks: MOST US

U.S. stock market map: IMAP US

Top stories on stocks: TOP STK

Stories on U.S. stocks: NI USS

--Editors: Max Berley, David Henry.