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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.

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