A.I.M. Users Bulletin Board

[The Grabber]

Interesting Article...

...read in this morning's business section.

One reason stocks moving in lock step? Exchange traded funds

Stocks don't typically move in lock step like this.

Now it seems when the Standard & Poor's 500 index is having a bad day the melancholy rubs off on thousands of other stocks too. Similarly, when the index is up dramatically, even the doggie stocks join the ride.

This is called correlation, meaning how closely the returns on two asset classes or sectors of the market move together. Several times in recent months the positive correlation between individual stocks and the S&P 500 index reached levels not seen in 20 years, according to a report by Richard Moroney, director of research at Dow Theory Forecast, an investing newsletter.

A correlation of 1.0 means two assets always move together, while a correlation of -1.0 means they move in opposite directions. During the European debt crisis last spring, the correlation between individual stocks and the S&P 500 hit 0.8 – a rarity reserved for extreme periods such as the Great Depression or the 1987 crash. This means that 80 percent of the stocks moved in the same direction as the index.

The correlation of the S&P 500 to other investments such as small stocks, commodities, international stocks and real estate hit a 20 year high in September. Moroney also found that the average correlation for stocks in the broader Russell 3000 index hit a record 0.7 in July.

Some of these correlations have since retreated slightly, but they remain high. Correlations routinely move higher during periods of high volatility because investors will indiscriminately dump stocks rather than try to pick winners from losers.

However, the fact that correlations remain high reflects that something else is in play. And that something else is investors' growing affinity for index mutual funds generally and exchange traded funds (ETFs) specifically.

ETFs are similar to mutual funds but they trade like stocks on the major exchanges. They have low fees, low turnover and offer investors exposure to major and minor indexes, bonds, gold, silver and the overseas markets. An ETF basically is a basket of stocks – passively managed – that offers investors exposure to a particular sector or corner of the market.

"I think ETFs are one of the main reasons for the high correlations we are seeing," said Charles Carlson, contributing editor of Dow Theory Forecasts. "They have created a basket investing environment as opposed to an individual stock investing environment."

The growth of ETFs has been steroidal. Today there are just over 1,000 ETFs with almost $1 trillion in assets compared with only 380 ETFs five years ago with $432 billion in assets. On any given day, ETFs account for about one-third of the trading volume on the major stock exchanges.

That means a flood of money is flowing into these baskets of stocks daily, and it doesn't discriminate between the fundamentally sound stocks and those that have problems. But the fact that many investors have given up on trying to pick quality stocks has actually created an opportunity for those savvy enough to try.

Moroney points out that many great stocks with rock solid fundamentals – companies like IBM Corp., Intel Corp. and Microsoft Corp. – are trading at deep discounts relative to the market. For example, the top 50 U.S. stocks currently have price-to-earnings (p/e) ratios about 19 percent lower than the average stock.

That's cheap when you consider that historically these top 50 stocks trade at a higher or premium p/e to the broader market.

While ETFs are certainly appropriate for a portion of a portfolio, Moroney advises investors not to put all their money into these products. Or as he put it: "Now is the time to look for top-choice stocks trading at hamburger valuations."