Correlation Gauging for Stock Picking in 2012

Stock Correlation Gauging Falls Dramatically for 2012 – a Bonus for Stock Pickers!

February 20, 2012

Introduction

During 2011, if you were a stock picker, there was little use in trying to pick winning or losing stocks, because they were all going in the same direction – stocks having a high correlation with each other. So far, in 2012, things have changed, and that's good news for all of the stock pickers in the market place. Correlations have fallen significantly this year, indicating it might be time once again to utilize this stock-picking prowess.

Definition of 'Stock Picking'

A “stock picker” is an analyst or investor who uses a systematic form of analysis to conclude that a particular stock will make a good investment and, therefore, should be added to his or her portfolio. The position can be either long or short and will depend on the analyst or investor's outlook for the particular stock's price.

Stock picking can be a very difficult process because there is never a foolproof way to determine what a stock's price will do in the future. However, by examining numerous factors, an investor may be able to get a better sense of future stock prices than by relying on guesswork. Because forecasting is not an exact science, an investor or analyst who uses any forecasting technique should include a margin of error in the calculations.

Correlation Gauging

To fully understand this concept there a few charts below that measure correlation. The first chart simply shows the average correlation of the S&P 500 stocks to the S&P 500 Index (SPX). A correlation of 100% means they move exactly alike. Note that in 2011 this number peaked around 90%, and spent most of the year above 80%. In 2012, it has fallen dramatically, and currently stands around 43%.

Definition of 'Correlation'

In relation to the stock market, hence the world of finance, “correlation” is a statistical measure of how two securities moves in relation to each other. Correlations are used in advanced portfolio management.

Correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep, in the same direction. Alternatively, perfect negative correlation means that if one security moves in either direction the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

In real life, perfectly correlated securities are rare; rather you will find securities with some degree of correlation.

Another, more intuitive way to use correlation gauging is to simply look at the percentage of stocks that move in the same direction as the market. A selection of stocks were made -- the chart shows how many stocks moved in the same direction as the SPX on a daily basis over the last 20 trading days. The current reading for correlation gauging is right around 60%, which is near the lows over about the last decade.

While 60% is low during recent times, it's actually quite high when you look over a longer time frame. The chart below shows the reading hovered right around 50% for 20 years before it began rising during the tech boom of the late 1990s, and then moved to a permanently higher plateau after 2000.

Best & Worst Stocks So Far for 2012

As it is now a stock-pickers market it is of interest to see what the best and worst stocks so far this year. Below are the 25 best and worst stocks in 2012, among all equities that are at least \$10 per share, and have traded at least one million shares per day.

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