Thursday, July 22, 2010

The Herd Instinct: Correlation Soars

Here's a Wall Street Journal article on how much more correlated stocks have become recently.

In a nutshell the article says:

Flock-like behavior is a reflection of the growing influence of investors using strategies to buy and sell large blocks of stocks.

Instead of picking individual stocks they trade in and out of the market using broad index ETFs.

Trading in exchange-traded funds means more stocks are likely to move in the same direction on any given day.

Correlation is on the rise which can be annoying to those who are buying individual stocks.

The average correlation since 1980 has been 44%.

Last week it surpassed its 2008 high of 79% and hit 81% (the highest level since the 1987 crash).

Here's my take. Lets say you want to buy a good business like Coca-Cola (KO). After you accumulate enough share at an attractive price, lets assume the correlation caused by the rapid fire trading of baskets of stocks described above occurs. In time, lets also say that these highly correlated daily price movements of KO with other stocks (some with clearly inferior economics) causes it to become mispriced. This would only be a bad thing if your investment horizon was a short one because...
  • At one extreme, if KO happened to stay cheap for a number of years both you as an investor and the company (using its own FCF) will be given the opportunity to buy more shares at that below intrinsic value price over time (increasing long-term returns).
  • At the other extreme, if the multiple of price to FCF becomes exceptionally high (think Coca-Cola in late 90s with 50 plus multiple), it allows the sale of shares at prices clearly well above intrinsic value (also increases returns).
So if you make a good judgment on what a business is worth and buy it with the right margin of safety, high correlation is either just noise* or opportunity in the long run.

With patience it can be used to enhance long-term returns.

Adam

Long KO

* In the context of investing for the long-term this is really just noise. If you look at this in a broader context, these swings from bubble to compressed valuations likely means a significant misallocation of capital is occurring. Allow it to persist and it will hurt the real economy and might, all else equal, cause living standards to improve at a reduced rate.
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