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November 10, 2011

How the Flash Crash Has Turned Stocks into Fish

They are many, yet they move as one. There are few things as mesmerizing as watching a school of fish. For no apparent reason, they all simultaneously turn in perfect choreography, and then the whole mass darts in a new direction.

Lately, watching stocks has become similarly mesmerizing, as they have shown signs of schooling behavior since the May 6 "flash crash."

On May 6, the market went nuts. As everyone knows by now, the indices plummeted, volume hit its high for the year, and the volatility index skyrocketed. Less known is that realized correlation also began a rapid climb that day. Correlation is a measure of how much of each stock's performance is linked to movements of the other stocks in the market. Given the crash, the climb in correlation was not a surprise to market professionals. Historically, correlation has moved in tandem with volatility--as markets get more uncertain, stocks tend to move together. In moments of great uncertainty, like the 1987 crash, stocks all plummet together; and then in the aftermath, they all roar back together.

But something odd happened after the flash fire was out. As volatility and volume both dropped in the ensuing weeks, and the markets calmed down again, correlation did something it was not supposed to do--it continued to shoot up. Realized correlation had been around 30 percent for most of 2010 prior to May 6. After the flash crash, despite volatility quickly dropping back to its pre-crash levels, correlation defied gravity, rising to a high of 74 percent in August. High realized correlations are important to investors--they are a way of saying that we are in a market where companies' stocks are not rewarded for good earnings or punished for bad results. Since May, stocks have moved in tandem like a school of fish--when one turns, they all turn.

The new stockquarium is causing frustration among traditional stock pickers. In September, the Wall Street Journal ran an article called "Macro Forces in Market Confound Stock Pickers," noting that the high measure of correlation was making stock picking "feel like an exercise in futility." As one longtime research analyst quoted in the article put it, "Stock picking is a dead art form." Picking individual stocks in a high-correlation environment is like betting on one fish within the school to race another to a distant finish. You know in advance that the entire school will get there at about the same time, so why bother?

The flash crash itself is the obvious suspect in this strange case of rising correlations. Is damaged investor confidence at the heart of this? The $57 billion in mutual fund outflows since the crash is frequently mentioned as proof of just that. At first, $57 billion sounds like an exodus of biblical proportions, until you learn the denominator is the $11 trillion that is invested in the U.S. equities market. Mutual fund outflows since the crash have actually been a drop in the ocean, well within their normal noise for the past 10 years.

But the rise in correlation is a tougher one to argue away. The most likely explanation is a form of damaged confidence: Since May 6, traders appear to have reassessed the risk of holding individual stocks.

Even a small change in traders' aversion to holding individual stocks could potentially have a big impact on correlation in 2010, because so much of today's market volume is generated from passive strategies that don't differentiate between individual stocks. ETFs have become so popular that they now typically account for 35 percent of the dollar value traded in the United States. As ETF desks routinely hedge their exposure, passive waves of buying and selling in the underlying stocks hit the market throughout the day. There are more than 1,000 ETFs listed on U.S. exchanges, with new ones rolling out every day. And even after May 6, domestic equity ETFs have continued to see significant inflows. On the mutual fund side, Morningstar data shows that unlike active funds, index funds have been steadily growing, with inflows in 34 of the past 36 months. Total indexed assets, including domestic ETFs, mutual funds and pension funds, are now estimated to be at an all-time high of $2.1 trillion, or about 19 percent of the total funds in the U.S. market.

All that capital sloshing around within passive funds may have set the stage for an explosion in correlation. Index funds behave very differently from traditional funds, and so as they grow, we should expect to see some odd dynamics in the markets. When index funds get inflows, they mechanically buy all the stocks in their index, and when they get outflows, they mechanically sell all the stocks. The logistics of running an index fund can be complex, and they are clearly providing a valuable service for their investors. Yet from an efficient market perspective, they are what economists would call "free riders"--contributing no information to the valuation process, while relying on others to keep individual stocks priced appropriately.

Thanks to the legions of analysts who spend their lonely evenings reading 10-Ks, and the institutional traders who selflessly slave away all day exchanging the latest news, the passive indexers can safely assume that all available public information will be quickly baked into stock prices without their help. As long as the active community is doing its job, stocks will be priced reasonably efficiently, allowing passive investors to safely buy and sell without doing any research themselves. But as with all free-rider situations, if too many people were to take advantage, a societal problem would emerge. Imagine if all the money moved to index funds. Individual stocks would no longer go up and down independently at all. CNBC would likely drop the ticker at the bottom of the screen, and just have a bar that said, "Everything down 0.4 percent today."

While we are still several trillion dollars away from CNBC dropping its ticker, we already are seeing a market where quaint things like earnings reports and cash flows appear to matter less than they once did, as stocks have acted like a giant school of fish. Fish get a lot of evolutionary advantages from schooling--moving within a crowd helps them avoid predators, helps them find food and helps them find mates. But stocks are arguably better off doing their own thing. Until correlation drops, and stocks stop being fish, many individual stocks inevitably must be priced at irrational levels.

Aren't the passive investors safe regardless, though? Worst-case scenario, they'll end up with the index return, and by definition that can't be so bad, right? As they say at poker games, if you can't spot the fish at the table, it's you.


Dan Mathisson, a managing director and the head of Advanced Execution Services at Credit Suisse, is a columnist for Traders Magazine. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.

The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com

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