THE BIG PICTURE: The herd mentality taking over markets

One issue that is starting to receive more attention is the correlation between individual stocks, sectors and sharemarkets. The Wall Street Journal ran an article entitled “The Herd Instinct Takes Over” citing research showing that stocks are trading in lock-step more than at any time since the 1987 sharemarket crash. The analysis indicates that investors are spending less time picking individual stocks, instead using broad-based techniques such as use of exchange-traded funds or program-trading techniques.

The research by Birinyi Associates measures the 50-day average correlation (co-movement) between the direction of the US S&P 500 index and that of its member stocks. A perfect correlation of 100% would mean that all member stocks track the index. The average correlation since 1980 is 44%. Last week the research found that the correlation hit 81% – the highest rate since the 1987 crash.

It’s unsure why the practice is occurring but it is disturbing. Perhaps professional investors believe that in terms of cost/benefit there is less value in spending the time to track a raft of stocks. Retail investors may also be disenchanted with ‘stock-picking’ and ‘buy and hold’ strategies, preferring exchange-trade funds.

And this practice doesn’t appear limited to just to US stocks – entire markets, such as our own sharemarket may be affected. It is difficult to know of course unless you surveyed a raft of hedge funds, fund managers, investment banks and professional traders, and clearly they wouldn’t be too keen to divulge too much about their strategies.

Still, it has been the case in Australia for some time that the ASX 200 has closely tracked the US Dow Jones index on a daily basis. In fact the simple daily correlation since January 2009 stands at 92%. The extent of that correlation is difficult to reconcile. For instance there has been a significant difference between Australian and US economies over that time. Interest rate levels are far different. And Australia has a higher proportion of stocks in the resources sector while the economy is tied more to China than the US.

Movements in the US sharemarket no doubt shape the futures market pricing and the correlation between changes in the overnight share price index futures contract and the physical index for the following day is also precise. In fact since the start of the year the correlation stands at 94%.

Take for instance trading on Thursday. The overnight SPI futures closed down 19 points on Thursday morning. At the end of trade on Thursday the ASX 200 was down 19.9 points. Much transpired over the day including a rash of Chinese economic data but the futures market estimate proved an eerily accurate predictor. Clearly it doesn’t always line up, with trade on Tuesday a case in point. Still it’s worth asking the question about role the research of individual stocks is playing in the broad movements of the sharemarket.

The week ahead

Economic events have dried up, with little in the way market-moving economic data, statements or speeches in the coming week. Instead the focus will shift to profit results to be issued from major US companies.

In Australia the highlight is a speech by the Reserve Bank Governor on Tuesday. The speech, entitled “Some Long-Run Effects of the Financial Crisis”, suggests that Glenn Stevens will spend most of the time focussing on medium-term issues. But many will also want to hear his views on short-term issues like the next batch of inflation figures and the implications for interest rates. Certainly if the Governor wants to send a message, this will be the forum to so.

Of the other events, again it is the Reserve Bank that is centre-stage with the minutes from the July 6 Board meeting to be released. The statement issued after that meeting contained a number of references to the inflation outlook, so financial market participants will be especially interested in any further details provided in the Board minutes.

In terms of economic data there are a few items on offer over the week. On Monday, June data on imports will be issued – one of the timeliest indicators of spending in the economy. On Tuesday there will be another reading on spending in the economy in the shape of CBA’s Business Spending Indicator. And then on Friday the “inflation reporting season” kicks off with data on export and import prices to be issued. The main drivers of prices tend to be the Aussie dollar, oil prices and other key commodity prices such as coal and iron ore. But the data may also give a sense about how prices of imported consumer goods are travelling and the implications for the consumer price index to be released on July 28.

The US economic calendar is also sparsely populated but again it will be the central bank – the Federal Reserve – that will be in the spotlight. Federal Reserve chairman Ben Bernanke delivers semi-annual testimony to the Senate Banking Committee on Wednesday and then follows this up a day later with testimony to the House of Representatives Financial Services Committee.

Minutes of the last Federal Reserve Open Market Committee meeting proved illuminating with members mulling whether they would need to provide further stimulus to the economy in coming months. Given that the Fed is still tipping ‘normal’ economic growth of around 3% this year, it is surprising that members are worried that economic momentum is slipping.

In terms of economic data in the US, figures on housing starts will be issued on Tuesday with existing home sales and leading indicators on Thursday. As always there are the weekly indicators to also consider such as department store sales, claims for unemployment insurance and new applications for home loans.

Sharemarket

A relative “Who’s Who” of the US corporate world will be reporting earnings over the next fortnight. So far earnings results have been encouraging, but clearly the results and future guidance will be pivotal for US and Australian sharemarkets.

Amongst the US companies reporting on Monday are IBM and Delta Airlines. Tuesday: Goldman Sachs, Bank of New York, Domino’s Pizza, Apple, Yahoo! and State Street. Wednesday: Morgan Stanley, US Airways, US Bancorp, Wells Fargo and eBay. Thursday: 3M, Caterpillar, American Express, E*TRADE and Microsoft. Friday: McDonalds and Kimberley Clark.

Interest rates, currencies & commodities

It’s amazing how quickly views can change. From mid May up until July 8, financial market pricing suggested that an interest rate cut was more likely than a rate hike. But stabilisation on equities markets, combined with stronger domestic employment and a rebound in consumer confidence and all of a sudden rate hikes are back on the menu. Current pricing suggests a 20% chance of a rate hike at the August meeting. Clearly inflation data on July 28 will be pivotal to views. But it is important to note that financial types aren’t getting carried away. The six-month overnight indexed swap rate stands at 4.60%, just above the current 4.50% cash rate.

Ninety-day bank bill yields have consistently held 30-40 basis points above the cash rate since late April with the current differential at 40 basis points. Bank bill futures are pointing to a modest lift in yields by the end of the year. Implied yields on 90-day bank bill yields stand at 4.92% with physical 90-day bills at 4.90%.

It may not be a major focus for farmers in Australia, but consumers (especially chocolate lovers) will be disappointed – cocoa prices have hit 32-year highs in London trade. While other commodity prices have mixed in recent months, cocoa prices have soared in response to strong demand in Europe. Supplies have also been constrained as a result of the de-stocking that occurred in 2008/09.

In the same vein, but with more relevance to Australian farmers, the sugar price has also gravitated higher over the past two months, lifting from lows of US13.70 cents a pound to around US17.30c/lb currently. One key development has been the news that the world’s second biggest exporter, Thailand, has had to buy back sugar to address a domestic shortage.

Craig James is chief economist at CommSec.