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Portfolio Strategy

Correlation And Macro Investing

Since the beginning of the financial crisis in '08, portfolio managers have repeatedly told me how difficult it has become to be a "stock-picker." Although fundamentals matter over the long-term, the short term has made the path to realizing that value unbearable and I have seen many fundamental investors partially or whole-heartedly change their stripes to being more macro-focused. I believe this is a bad idea. This is not to say that macro investing is a bad idea, but that it is probably not a particularly strong skill-set of the manager whom has been focused on fundamental investing for their whole career (previous post on macro investing, excerpt below*).

At first I focused on the VIX as a proxy for the level of difficulty for stock-pickers. Certainly there was some strong interdependence between the two in late '08 / early '09, but stock-picking has continued to be challenging even though the VIX has subsided. And as Seth Klarman said when discussing value investing, "think about volatility in markets as being in your favor rather than as a problem." So the VIX wasn't the proxy for difficult stock-picking, it was just a good high negative beta bet against the market. This makes sense once you think about how the VIX is calculated. The VIX is measured by taking the implied volatility of a chain of S&P 500 Index Options. As the price of options rises, so does the implied volatility given that the rest of the Black-Sholes pricing inputs are held constant. So in a falling market, investors tend to buy puts as protection which increases the price of puts but also increases the price of calls due to put-call parity. So, as the price of options increases so does the implied volatility. On the other hand, in times of rising markets, investors do not tend to purchase calls on the same order as puts are purchased on the downside, meaning that options prices do not increase as much during rising markets as they do in falling markets which makes the VIX highly negatively correlated with the markets. And also makes it a poor proxy for stock-pickers.

But recently I have seen references to a gauge that I didn't know was available, the CBOE Implied Correlation Index (JCJ Index on Bloomberg). The Correlation Index measures the correlation of stocks in the S&P 500 against each other, meaning that it suggests how much of the movement of stocks is related to the movement of other stocks. Now this makes logical sense as a good proxy for the level of difficulty for stock-pickers because it shows the ease or difficulty in realizing idiosyncratic moves versus systematic moves in a stock. Right now the JCJ is trading at 65, which means that 65% of the movement of the average stock in the S&P 500 is explained by the movement of other stocks in the S&P 500. No wonder fundamental investors are considering following a macro strategy. Needless to say it is difficult to tease out the value when correlation is so high. "High levels of correlation can create a serious challenge for long-short managers. While a long-short portfolio may yield up to twice as much as a long-only portfolio in a low-correlation environment, its performance may converge towards zero as correlation reaches extreme levels," Marko Kolanovic, JP Morgan Securities. Please check out JP Morgan's great report on the subject – "Why We Have a Correlation Bubble" by Marko Kolanovic.

Historical correlation for the stocks in the S&P 500 is a little less than 30%. That means we are substantially above norm. Check out the breakdown by industry compared to historical levels:

I am not sure exactly how this should change a fundamental investor's strategy, but I think at a bare minimum it should be tracked as a measure of solace that the stock-picking difficulty you are experiencing is in a historically unsustainable state. For those that would want to use the Correlation measure more aggressively, they could decrease their gross exposure in environments of high correlation as it represents a period where their skill is not translated into an outcome as effectively.

Alpha Theory is currently building an index-adjusted risk-adjusted return so that users that do not want to trade around the volatility will get a risk-adjusted return which is muted by the movement of the underlying index. For instance, if a user has a 30% risk-adjusted return for IBM and the S&P 500 and IBM go up by 10%, the risk-adjusted return of IBM would stay constant at 30%. This method is not the best way to "Capitalize on the Random Walk" (Click on #8 - Capitalize on the Random Walk) of the market but it will help lessen some of the non-idiosyncratic buy and sell recommendations coming out of Alpha Theory.

*Top-down can be a great way to focus on regions, sectors, and industries that you believe will outperform and then find good bargains in those regions or themes. Additionally, it makes sense to protect against macro-factors which you believe have a reasonable probability of occurrence and would adversely affect your portfolio like the fear of inflation or dollar devaluation. But that does not mean that stock pickers should all of a sudden be betting on the direction of indexes, currency, or sovereign debt.

As Bill Ackman said, "We spend little time trying to outguess market prognosticators about the short-term future of the markets or the economy for the purpose of deciding whether or not to invest.  Since we believe that short-term market and economic prognostication is largely a fool's errand, we invest according to a strategy that makes the need to rely on short-term market or economic assessments largely irrelevant."

Market and economic direction are multi-variable equations with thousands of inputs.  You can find two Nobel Laureate economists with well-defended theses for divergent directions of the US economy.  If they cannot figure it out, why should you try?  Mental capacity is a precious commodity and should be focused on reasonable prognostication, not on knowing the unknowable.

Portfolio Strategy