I’ve written about the correlation (or lack thereof) between individual stocks many times.
In our January 2013 forecast issue of Boom & Bust, I predicted that correlations would decline this year, making the market ripe for stock pickers willing to invest outside the averages.
As the year unfolded, correlations indeed came down. In fact, in April, I wrote about declining correlations seen at the stock level, sector level and country level (here) and the relationship between correlations and volatility (here).
Today, I’ll share a chart that shows that the correlation between S&P 500 stocks has dropped even further.
Correlations are now below 20%, which seems to be the lower bound over the past five years.
Some believe this situation is a cause for concern, citing anecdotal evidence that shows correlations are often low at market peaks.
But I view low correlations differently… mainly because much of my investment philosophy hinges on relativity, particularly relative relationships. (A philosophy I picked up from Albert Einstein, who I’m sure would be a stock picker in today’s market.)
That’s the case for my trading service, Cycle 9 Alert, where I use relative performance (against the S&P 500) to determine which sectors are the strongest, and then which stocks (in the strongest sectors) are poised to pop higher. This analysis is particularly lucrative in low-correlation environments, like we see today.
The same goes for spread trades, where we buy shares of one company, while simultaneously selling short the shares of another company.
That’s what I recently recommended you do with two fertilizer companies, Agrium (AGU) and Potash Corp. of Saskatchewan (POT). The goal was to mitigate the broad market- and sector-related factors that would cause these stocks to move up or down, and instead take advantage of the specific differences between the two companies (mainly that POT is more exposed to the potash market, where AGU is more diversified). Again, these spread trades are potentially more lucrative in a low-correlation environment.
It’s only been a few days since I recommended this spread trade, but it’s already showing an open gain of about 3.5%.
Both stocks are down… but POT is down more, having lost 3.6% since Friday, compared to Agrium’s loss of just 0.1%.
That’s the beauty of spread trades. You can make money if both stocks move up, or if both stocks move down.
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