So Long, Stock Picking

Includes: SPY, VXX
by: optionMONSTER

By Chris McKhann

Stock picking is dead ... again.

The correlation of the S&P 500 has reached record levels, meaning that stocks rise and fall pretty much as one. Fundamentals don’t differentiate when correlation is so high and all boats rise and fall on the same tide. As a result, long-only managers aren’t able to add much in this market.

It's especially hard on mutual funds, which tend to stay fully invested. They're not paid by absolute performance, and so usually don't try to limit losses, as long as they remain ahead of their Index. But even that proves almost with high correlation. Studies have shown that most active fund managers don’t beat the Indexes after fees.

Many investors therefore turn to Index funds, and that may in turn exacerbate the high correlation. High volatility and bearish markets have also typically gone hand in hand. There also seem to be some new dynamics at work, such as the "the machines" and high frequency trading. Another factor is probably hedging that uses broad based options. After all, we have seen record volumes in SPY, SPX and VIX options and futures over the last couple of months.

High correlation won’t last -- at least not at these levels. So stock picking isn’t working right now, but its day will return. Nonetheless, the recent changes to the trading landscape are here to stay, and traders should think of ways to put it to their advantage.