* Excellent Book - I've started reading Richard Bookstaber's very engaging "A Demon of Our Own Design", an explanation of how the complex strategies utilized by the most sophisticated trading firms end up contributing to unforeseen market crises. I particularly like this quote:"As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is that you cannot always predict ahead of time if the correlation will be positive or negative." - p. 26
This dynamic--instruments becoming increasingly correlated during buying and selling panics--occurs on multiple time frames and across varying widths of asset classes. A simple panicky selloff in stocks may tank all sectors, for example, but not necessarily spread to bonds. One implication is that you can quantify panics by the breadth of the increased correlations and by their duration.
Bookstaber's observation is that such periods of unusual correlation can also represent "spectacular profit opportunities for those who can stand the heat" (p. 26). Might a multiple correlation indicator provide insight into those emotional periods when traders grab or toss aside all stocks indiscriminately, creating inefficiencies (temporary inflation of bad stocks/sectors; temporary depression of good stocks/sectors)? Food for research...
* A Number of Valuable Ideas - Take a look at the most recent links posted by The Kirk Report, particularly the articles on the prospects for rate hikes; cardboard box production as an economic indicator; hedge fund leverage as a recipe for market disaster; and a Senator's view on a major threat that could capsize the economy. Great stuff.
* How to Track Hundreds of Financial Blogs - Craig of TAZ Trader Blog very helpfully walks readers through the process of subscribing to a reader and adding favorite blogs for automatic updating. Also check out their post on action zones for swing trades, designed to capture market reversals.
* Another Stock on My Radar - ADBE has positioned itself very well for the digital publishing age. This includes such online developments as its Creative Suite, but also underappreciated potentials for Acrobat as a vehicle for rich multimedia publication. Analysts expect a good earnings report for Thursday; the chart above shows that we've had solidly rising dollar volume flows into the stock over the last 200 days--a good sign of institutional sponsorship. Money flows over the past 10 trading sessions have pulled back to their 200-day average: a situation that has marked recent buying opportunities.
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4 comments:
You wrote:
"As the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is that you cannot always predict ahead of time if the correlation will be positive or negative."
The key sentence is "The problem is that you cannot always predict ahead of time if the correlation will be positive or negative." This is also the reason that I find your advocation of "identifying and trading a dominant market theme" highly dangerous. My point is you never know when these intermarket relationships will cease to work.
For example, in your earlier posts, you identify the inter relationship between Dollar Yen and the stock market. You postulated that Dollar Yen carry trade acts as the liquidity tap and when the Yen strengthens against the Dollar, this hurts a lot of the carry trade people and turns off the liquidity tap and therefore resulted in a fall of the stock market, e.g like in Feb. to March this year when both Dollar Yen and the stock market fell.
However, in the latest weakness of the equity markets, Dollar Yen did not fall but continues to go up (at 122.40 as I write now). So this inter market relationship broke down.
Your latest pet theme is the inverse relationship between bond yields and equity markets. However, I remember there was a time when bond yields and the stock market decoupled. So you never know when this is going to happen.
Trading such inter-market themes is in reality trading based on what you "THINK" should happen. You are not trading what you "SEE". What you think should happen can get you into big time trouble, e.g. just ask LTCM in their inter-market convergence trade. Along came a black swan event like Russian default and these inter-market them bets blew up LTCM.
Then again, when traders go bust trading inter-market themes as you suggested, they will of course need to hire you as their trading coach and figure what went wrong.
Good post. I keep around a variety of systemic risk tracking variables to help me during crises. In addition to the correlation coefficients, other useful variables include implied volatilities from equities, bonds, and currencies. Bond and swap spreads are a similar phenomenon -- when they stop gapping out, markets tend to rally. Then there is the Merger Fund [MERFX]. Anytime systemic risk pops up, it goes down. Merger arbitrage gets afraid when volatility rises, leading them to worry about deals not closing.
I also look for what might be failing during the crisis, and ask whether it is big enough to do significant damage to trelated parts of the market. Most of the time it is not big enough, but you always have to check. During the recent troubles in February/March I concluded relatively early that it would not be a significant problem, because the subprime asset transactions got done at small discounts to par.
Keep up the good work.
David Merkel
http://alephblog.com
Hi PWH,
You raise an important point: these themes come and go, and it's important to be able to be flexible in your thinking to accomodate that fact. That having been said, a number of traders I work with use correlational methods to track the rise and fall of themes and trade these selectively on that basis. That enables them to be quite effective and profitable. But you're right: blind and rigid following of a theme is a disaster waiting to happen.
Brett
Hello David,
Thanks for your very perceptive comments, esp re: the Merger Fund and the importance of tracking multiple markets during potential crisis. I find such an awareness of the interrelatedness of asset classes to be missing among many traders. It adds an important dimension to trading at times of turbulence. Do stay in touch!
Brett
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