Winner, Winner… Chicken Dinner

I was flipping through a J.P. Morgan Asset Management report this morning when a chart on correlations caught my eye. It reminded me of a view I shared with Boom & Bust subscribers when we wrapped up our January forecast issue.

Basically, I told subscribers to expect a low volatility market in the first half of 2013 – a ripe environment for “stock pickers.” Here’s what I said:

Stock market correlation measures to what degree stocks move in sync. When correlations are high, most stocks move up and down together, nearly in lock- step. When correlations are low, stock prices move independently of one another.

Looking ahead to 2013, I expect stock market correlations to decline as long as the market remains in a long-term uptrend. This is fairly typical of later-stage bull markets. In late 2000, the correlation between stocks was at a multi-year low of roughly 18%. Compare that to correlations as high as 80% just prior to the collapse of Lehman Brother in 2008, then again in 2010 as Greece first asked for aid.

Low correlation markets make stock-picking more lucrative. Analysis of individual company fundamentals and industry-specific trends will pay off handsomely in early 2013 as the market pushes upward.

And here’s the chart that caught my eye this morning:

See larger image

Two things to note here…

First, notice that stock market correlations tend to track volatility. When volatility is high, correlations are strong and most stocks move together. Likewise, when volatility is low, or decreasing, individual stocks decouple from one another, moving higher or lower based on industry- and company-specific factors.

Second, while the current large-cap stock correlation is relatively low at 34.5%, it is still above the long-term average of 26.7%. What’s more, it’s nowhere near as low as correlations were at the 2000 bubble-peak.

This tells me we’re still in a perfect market for stock picking! There’s no need to “hide” in the averages… this is the environment where you roll up your sleeves, dig deep, and hunt for the market’s strongest (and weakest, if you’re a short-seller) plays.

And that’s what I’ve done for Boom & Bust subscribers over the past 18 months. The model portfolio I’ve built is doing very well. Based on year-to-date prices we’re netting open gains ranging from 3.5% to 13%… to 29%. And that’s just in the last three months, as the S&P 500 has pushed higher by about 7%.

Plus, I’ve found profitable plays on the downside too. Take for instance the sell short recommendation I issued to Boom & Bust subscribers just last Wednesday. I found what I think is the weakest company in a troubled sector. Now, our bet against this stock is already handing us gains of more than 10%. And there’s still time to make this play yourself.

Bottom line: not all stocks are created equal.

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Categories: Markets

About Author

Adam O'Dell has one purpose in mind: to find and bring to subscribers investment opportunities that return the maximum profit with the minimum risk. Adam has worked as a Prop Trader for a spot Forex firm. While there, he learned the fundamentals of trading in the world’s largest market. He excelled at trading the volatile currency markets by seeking out low-risk entry points for trades with high profit potential. An MBA graduate and Affiliate Member of the Market Technicians Association, Adam is a lifelong student of the markets. He is editor of our hugely successful trading service, Cycle 9 Alert.