You Can No Longer Rely on the S&P 500 – Here’s Why

You may have heard some buzz recently about how the S&P 500 and the Dow are simply no longer correlated. In fact, they’re more disconnected now than they’ve been in over 13 years.

And while this sounds more like some analytical jargon that really doesn’t matter…

It’s actually crucial to your portfolio’s returns.

Here’s why…

The Understated Significance of Correlation to Your Portfolio

When it comes to the financial markets, “correlation” is a statistic that measures the degree to which two securities move in relation to each other. It’s computed into what’s called the “correlation coefficient,” with a value calculated between -1 and 1.

There’s three types of correlation:

  1. Perfect Positive Correlation: This means that the correlation coefficient is exactly 1. This tells you that the two securities are moving in the same direction in the same manner.
  2. Perfect Negative Correlation: This means that the two  correlation coefficient is -1. This tells you that the two securities are moving in opposite directions in the same manner.
  3. Zero correlation: This means that there’s no correlation between the two securities.

Typically, two of the major indices, the Dow Jones Industrial Average (DJIA) and the S&P 500 (SPX), move together like they’re running a two-legged race at the exact same rate of speed (positive correlation). But we’re now seeing seeing the lowest level of correlation between them since April 4, 2003. In fact, their 15-year average correlation is nearly perfect at 0.9557 while their rolling, 20-day correlation is only at 0.4655.

Image provided by www.marketwatch.comImage provided by www.marketwatch.com

In other words, the correlation between the DJIA and SPX just isn’t what it used to be, thanks in part to the recent downturn in the tech sector and investors transferring their money out of those stocks and into bank stocks.

That’s exactly why it’s important to not just look at one index to get a gauge of the overall stock market. In fact, a lot of people tend to do this as a way of determining which funds to buy and sell (which is something I wouldn’t encourage anyway). But given the huge disconnect we’re seeing now – ¬†that strategy could prove to be detrimental – if not fatal – to your portfolio.

Instead, consider tracking the correlation of the funds you’re interested in to get a sense of how closely they’re moving with the major indices. That way, if a sector within a major index isn’t as strong and is stalling the performance of the broader index, you’re able to find pinpoint those stocks that are just as strong.

Now I use my proprietary tools to scan for stocks that correlate the most to an index or exchange traded fund (ETF). For example, this is what populated in a recent scan of highly correlated stocks:

DIA-Stock-Correlations

Of these securities, the three “pure” stocks that are in the top ten as far as their correlation to the SPDR Dow Jones Industrial Average ETF (DIA) are:

Southwest Airlines Co. (LUV)

SodaStream International Ltd. (SODA)

The Boeing Company (BA)

But you can do the same by using any asset correlation calculator, such as the Chicago Board Options Exchange Correlation Indicator, with the idea of looking for stocks showing more strength. As an investor, you consider those stocks to add to your portfolio. As an options trader, you can consider call options trades, Longterm Anticipation Securities (LEAPs), or even calendar spreads.

To your continued success,

Tom Gentile

P.S. Over FORTY double- and triple-digit winners… now it’s YOUR turn.

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