Come On Feel the Noise

Trying to hear winners in a loud, correlated world.

August 16, 2010

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88150_volume_controlIf stock markets were well behaved, then the babysitters (read: fund managers, analysts and prognosticators) would have to find other lines of work. Wrought-iron fencing comes to mind – but only because this author lives next-door to a wrought-iron fencemaker. It’s lovely stuff. It also makes for a noisy neighbourhood.

Speaking of noise, what to do in a market with near 100% correlations? Tyler Durdan at Zero Hedge reports on the latest from Barclays Capital’s quant group. Barclays head of quantative strategy, Matt Rothman, describes yawing volatility, noting that all stocks seem to move at something close to the same rate – 70% of the time. Evidently there are leaders and followers – but few lone wolves. Or, as Rothman puts it:

“low levels of stock dispersion generally correspond with difficulty in picking individual stocks. For as stocks movements increasingly coincide, the unique individual components of a stock’s story tend to shrink in importance and the common and systemic (macro) factors gain in importance. As macro-economic factors dominate a market, how a stock is exposed to those factors will become the principal determinant of that stock’s return. These heightened levels of cross-sectional correlation today hold across sectors with most every sector near historically high levels.”

When there’s monotonous noise in markets – when all stocks resound with the same unpleasant harmony (think of a hammer hitting metal, day in and day out) – there’s little point in shifting from the primary residence to the cottage – there will doubtless be headbangers at the lake.

Or not, suggests Rothman.

“This high level of cross-sectional correlation also has implications for how certain characteristics are being priced. For if stock return dispersion is low but underlying fundamental (economic) performance of factors remains relatively constant then it would appear that mispricings in the market may be beginning to take root.”

Hold onto those Muskoka chairs. There may be some interesting dispersions in coming months.

Or as Rothman writes: “the valuation spread between Quality companies is at the lower end of its historical range – high Quality companies are cheap right now relative to low Quality companies.”

Sometimes it’s hard to hear that through the headbanging noise.

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