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Mark Hulbert Archives | Email alerts
Nov. 2, 2011, 12:03 a.m. EDT
By Mark Hulbert, MarketWatch
CHAPEL HILL, N.C. (MarketWatch) "” There were very few safe ports in the storm that hit Wall Street on Tuesday: Almost all stocks fell.
This, along with other similarly lopsided sessions in recent days, will undoubtedly lead to breathless declarations on Wall Street that the trading environment has fundamentally changed: Instead of a market of individual stocks, we'll surely be told, it is now a stock market.
Don't believe it. The trading environment has not changed. Superior stock picking remains as possible"”and as valuable"”as ever.
MarketWatch columnist Mark Hulbert says current market turmoil is giving the appearance, mostly unjustified, that stocks are entering a new era where their movements are closely correlated together.
Those concluding that it isn't are guilty of a fundamental misunderstanding of the ways in which stocks are now"”and have always been"”correlated with each other.
One source of this misunderstanding is statistical: It turns out that increased market volatility more or less automatically leads to heightened estimates of stocks' correlation"”even when nothing has really changed.
This unfortunate statistical bias in the correlation coefficient was discovered more than a decade ago, at least in academic circles.
Kristin Forbes, a professor of management and global economics at MIT, was one of the researchers who first pointed out this bias. In an interview earlier this week, she told me she suspects that this bias is playing a major role in leading analysts to falsely conclude that correlations have increased: "At least some of the increased correlation we have seen recently is a statistical artifact of the market's increased volatility," she said.
Another reason why analysts may be making too big a deal of the apparent increase in stocks' behaving in unison: Correlations almost always are greater during market declines than in rallies. Once again, this is nothing new. This asymmetry of the markets has been known and widely recognized for more than a decade, at least among academic researchers.
Both of these factors are conspiring right now to increase stocks' correlations. Not only have we experienced extraordinary volatility, but the market in recent months has been in an overall downtrend.
No wonder it has appeared that we're in a monolithic stock market rather than a market of idiosyncratic individual stocks.
But that appearance doesn't mean much has really changed. As Professor Forbes put it: "We're in a highly interdependent world all the time. We are just more aware of it during volatile periods and down markets."
Allan Timmermann, an economics professor at the University of California (San Diego), adds that we should expect heightened volatility for some time to come. Timmermann, who has extensively studied the asymmetry in stocks' correlations during up and down markets, pointed out in an interview that volatile periods in the markets tend to be clustered together.
He likened this tendency to the turbulence that leads airline pilots to require travellers to take their seats and fasten their seatbelts. If turbulence occurred randomly, then this requirement would make little sense. But it doesn't occur randomly: Because pockets of turbulence are clustered together, pilots can turn on the seatbelt sign after the first experience of such turbulence, and turn it back off after the ride has been smooth for a while.
The same is true for the stock market, Timmerman said.
Which suggests that investors may themselves want to take their seats and fasten their seatbelts.
Click here to learn more about the Hulbert Financial Digest.
Mark Hulbert is the founder of Hulbert Financial Digest in Annandale, Va. He has been tracking the advice of more than 160 financial newsletters since 1980.
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Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD... Expand
Mark Hulbert is editor of the Hulbert Financial Digest, which since 1980 has been tracking the performance of hundreds of investment advisors. The HFD became a service of MarketWatch in April 2002. In addition to being a Senior Columnist for MarketWatch, Hulbert writes a monthly column for Barron's.com and a column on investment strategies for the Journal of the American Association of Individual Investors. A frequent guest on television and radio shows, you may have seen Hulbert on CNBC, Wall Street Week, or ABC's World News This Morning. Most recently, Dow Jones and MarketWatch launched a new weekly newsletter based on Hulbert's research, entitled Hulbert on Markets: What's Working Now. Collapse
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