High stock market correlation: the future of technical analysis
Stock picking is dead, learn technical analysis
I wrote this story some time back “If two stocks are fundamentally as good, does stock picking help?”
Putting side by side the charts of Cathay Pacific and Singapore Airlines, I found that they display the same price signals. I drew this conclusion:
rather than learn to pick stocks, it might be a superior skill to recognize which part of the price cycle we are in
Why? Because besides individual stocks, stock market correlation is increasing everywhere. So much so that recently, a paper was published to discuss this phenomenon. Interestingly its name is “Nowhere left to hide“. But goodness I am only proposing individuals pick up technical analysis – not making a case to invest in Africa.
The stock price of Cathay Pacific and Singapore Airlines display high stock market correlation
What is market correlation? It is a statistical measure that looks at how closely two securities move in relation to each other. Let me try to put this in layman’s words.
- If two securities move together in the same direction and by the same extent, they exhibit strong positive market correlation.
- If they move by same extent but in totally opposite direction, they exhibit strong negative market correlation.
- If their movement appears to be random and not related to each other, they exhibit no correlation.
Market correlation is important to investors who want to achieve portfolio diversification and protection. A diversified portfolio must not hold securities that have strong correlation. Otherwise securities in the portfolio share the same risk ‘footprint’. Traders who hedge their position also look at market correlation. A hedged position may employ securities that minimize correlation.
In my humble not expert opinion, it appears that market correlation is also an important aspect of trading/investing performance. Because if all securities exhibit strong correlation, how can any trader achieve superior performance from anywhere through picking?
Other signs of stock market correlation besides individual stocks
Stock indices of three major ASEAN economies
This monthly chart shows three stock indices.
- Black line – Stock Exchange of Thailand SET Index (SET)
- Blue line – FTSE Bursa Malaysia Kuala Lumpur Composite Index (KLSE)
- Red line – FTSE Straits Times Index (STI)
The three indices overlaid shows visually positive market correlation. It appears even more pronounced since 2009. In a region where the economies have strong trade relationship, perhaps this is unsurprising. But let’s go to the next chart.
Stock indices of three major ASEAN economies + the German DAX index + the S&P500
In this monthly chart, two more lines were added.
- Green line – S&P 500
- Pink line – German DAX
The positive and to me very strong market correlation is now jaw-dropping. What does this mean?
Technical Analysis (market timing) is the way to trade and invest in future
Stock picking using fundamental analysis have always been challenging to individuals. Besides requiring alot of expertise and business acumen, individuals have always been challenged to acquire timely and reliable information. If securities are strongly correlated, then investing time and effort to do fundamental analysis may not deliver superior results anyway. This was visible in the comparison of prices of Cathay Pacific and Singapore Airlines.
Although technical analysis does not appeal to some segments of investors because it is not a science, it is very easy to pick up for individuals. Technical analysis contributes to market timing and as the charts above show, making money from financial markets may ultimately come down to getting the timing right.