Wednesday, June 13, 2007

Stock Market Correlations and Other Wednesday Ideas

* 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.