|Written by Jared Levy, Editor, Option Strategies Weekly|
|Tuesday, 30 August 2011 09:58|
Those of you who know me know that I love statistics and that I’m always looking for ANYTHING that gives me an “edge” or “early warning signal.”
I use statistics to predicted major movements in the market. Some signals are bullish, like this one I wrote about in Smart Investing Daily on June 7th.
Just recently I found an abnormality in the way that options were being priced and traded. Back on July 22nd, the signals I saw were pointing to move sharply lower in the Nasdaq and S&P 500. Sure enough, these indexes dropped 18% almost immediately.
I find these early warning signals in charts, trade volume, options, news stories, and in abnormal trading activity. I also find signals in correlations between securities. (This is one of my favorite signals.) But correlations can hard to spot.
Correlations in the Market
Believe it or not, just about every investor has come across a correlation in their analysis. For example, many investors look at something called beta. A stock’s beta tells us how volatile it is compared to the market. If a stock has a beta of 1 it should be moving at about the same rate as the index it belongs to.
For example, Google (GOOG:NASDAQ) has a beta of 1.13, which means that if the market is up 1%, Google is going to be up about 1.13% on average.
Stocks can have negative betas as well. The company China Green Agriculture Inc. (CGA:NYSE) has a beta of -5.52, which means if the market is up 1%, chances are this stock is going to be DOWN 5.52% on average.
Most stocks, commodities and metals have natural relationships with one another. When these correlations become “disconnected,” it can be a sign that something is wrong.
Major disconnections can be a warning to investors… and an opportunity if you know what to look for.
VIX is the Ultimate Negative Correlation
The pros know that the VIX, which measures option prices in the S&P 500, is about as opposite to the overall market as one can get when it comes to correlations.
In fact, if you look at the graph below, you can see that the 60-day correlation is -0.882. This means that when the market is up 1%, the VIX has been down an average of 0.882% over the past 60 days.
Courtesy of AI Stock Charts
It is “normal” and widely accepted that the VIX moves negative to the markets. It has been that way since the VIX was created.
So if the market was rising and the VIX was rising along with it, we would have a bunch of Wall Street pros scratching their heads. More accurately, they would probably be selling their stock positions. That’s because if stocks are rising and option values are rising along with it, it means one of two things:
a. Investors are buying massive amounts of option “insurance” because they don’t believe in the rally (in other words, buying put options).
b. The smart-money investors see big volatility to come, so they are buying calls and puts because they are unsure about direction.
Either way, it’s not a good time to be long stocks.
Funny Things are Happening in Gold
Just like the VIX, gold has a long-lasting relationship with the stock market. When the market is rising, gold is usually dropping, and vice-versa.
You see, gold is a safe haven. Every analyst I work with has written about it and knows the story. We have also been telling you to buy gold since early last year.
When investors are all warm and fuzzy inside, they sell gold and buy stocks. The historical correlation between the SPDR Gold Trust ETF (GLD:NYSE) and the SPDR S&P 500 ETF (SPY:NYSE) shows that they have a low to negative correlation of about -0.10 to -0.50. So if the market is falling, there is a good chance gold is on the way up.
But what if things start changing? What if the gold correlation breaks down?For the six months leading up to the crash in October 2007, gold started moving almost in lockstep with the market. It jumped in correlation to 0.40, meaning that when markets climbed 1%, gold climbed 0.40%.
This was very unusual for gold… It’s like gold knew abut the crash before it happened!
Another way to explain this correlation would be to compare it to the normal reaction people have to a burning building. Normally people will run as fast as they can AWAY from a burning building. This can be thought of as a “normal negative correlation.” If you were to notice people running into a burning building, wouldn’t you be puzzled?
In the stock market, noticing these disconnected correlations is not usually that easy.
Well, let’s take that a step further. Spotting the effect might be easy, but finding the cause takes skill.Sometimes it takes complex mathematical calculations. But you can do a simple test yourself. Just look at a daily chart of the SPY compared to GLD and see if they are moving together or apart. If they start to move together, you need to be cautious in the short term.
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The Recent Downturn
I was running some tests, and sure enough, on June 24th — right before the first correction in the stock market — the GLD to SPY correlation shot back up to 0.36, which is historically high and close to where it was back in October of 2007. Remember, I am looking at how gold investors act when the market is moving higher.
If the two start to become highly correlated, it is a warning signal. Fear is brewing and it may be time to sell your long postions, at least partially.
This is the canary in the coal mine.
In Option Strategies Weekly, I use this along with other indicators to help me predict market direction.
For the past 30 days, investors have been getting pummeled in stocks and buying gold like there is no tomorrow. This means that the relationship has swung into deep negative-correlation territory (-0.57).
Your parents probably taught you that most things are okay in moderation. The markets think the same way. Right now the pendulum is swinging toward major fear, which means that gold and volaltility will remain high and market gains will be suppressed.
With the big runup in gold, expect it to be EXTRA senstive and remain negatively correlated to the markets.
If the market begins to climb again, be sure that gold is not climbing with it. That said, I would be a very cautious buyer of the market up until 1,260, but NOT if gold continues to rise with it!
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