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Tuesday, June 1, 2010

When stocks go down, what goes up?

Jim Cramer used to do a segment on his show called, "Am I diversified?" where he invited callers to tell him their portfolios and he would bless them (or not) as being diversified. The gist of the segment was that he wanted them to have stocks in different sectors, different market caps, etc - in the theory that a "diversified" portfolio would smooth out the overall performance.

To which I'd want to ask, "And how'd that work out for ya in the last bear market?"

As it is now probably readily apparent to most everyone, the stock market (be it small, mid, large, foreign, or domestic) is highly correlated and will generally rise or fall in unison.

The best way to be diversified, or to simply own stocks that "zig when the market zags" - is to own stocks that have a negative correlation with each other. Although this sounds straight-forward, seemingly no one in the public eye can get this right. Fortunately for us, figuring it out is actually pretty easy.

First, you need two tools:
  • Historic stock prices (which you can easily get by going to Yahoo Finance, selecting a stock, clicking the "Historical Prices" link on the left, scrolling to the bottom, and clicking the "Download to Spreadsheet" link)
  • Excel (or some comparable spreadsheet program with which to open said spreadsheet)
Once you've down this for two stocks, you can correlate their prices by using the CORREL() function.

Here is what the function looks like to correlate the last 100 trading days for two stocks that are populated in the A and B columns in a spreadsheet:

=CORREL(A1:A100,B1:B100)

Here is a sample spreadsheet that I put together for SPY, EFA, TLT, GLD, UUP, and SDS with data going back to the beginning of 2009.


It is noteworthy to point out:
  • EFA, which represents major European and Asian markets - is very strongly correlated with domestic stocks
  • Despite popular perception - gold has a strong POSITIVE correlation with the market.
  • The correlation between stocks and bonds is negative, but not overwhelmingly so
  • A stronger negative correlation exists between stocks and the dollar index.
The values of the correlation will range from +1 (high positive correlation) to -1 (high negative correlation). If you're trying to buy a stock that will go up when the market goes down - you want one with a correlation to SPY as close to -1 as possible. Lately, that means you should be buying dollars.

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