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Financial market correlation hits new peak

Financial Events
By Paul Hodges on 23-Feb-2012

WTIvS&P Feb12.pngThe US S&P 500 is the most important stock index in the world. It contains 500 different major companies, in a wide variety of industries, and has been calculated since 1957.

There has never been a day when all 500 stocks moved in the same direction. This is not surprising, as good news for one company or industry can often be bad news for another.

Until June last year, there had only been 5 days when 490 of the stocks moved together, after an external event such as the 9/11 tragedy.

Yet in just the second half of last year, according to the Financial Times, there were 6 days when 490 stocks all moved together. This is the ‘correlation trade’ in action. And as the chart above shows, the correlations extend across markets and include oil prices.

The reason is the rise of high-frequency trading. These are computer ‘black-boxes’ which are programmed with complex algorithms to trade vast numbers of contracts on a micro-second by micro-second basis.

They account for 70% of all US equity trading. But they do not exist to perform the usual function of financial markets, which is price discovery. Nor do they provide liquidity, as the boxes only trade when they choose.

Now a major new study shows how this “computerised trading has created a new world, one where the usual rules don’t apply, populated by algorithms and only dimly understood by the people who made them“.

The study looks at 5 years of recent trading history for the S&P 500. And it looks at it in detail – at below the 950 millisecond level, which is where the high-frequency trading takes place. It also notes that speeds are increasing all the time:

• One new computer chip built specifically for high-frequency trading can prepare trades in 0.000000074 seconds
• A £200m ($320m) transatlantic cable is being built just to shave 0.006 seconds off transaction times between New York City and London

It is very hard to see what value this trading provides, except to the owners of the ‘black boxes’. And even they are at risk, as we saw during the so-called ‘flash-crash’ of May 2010, when the computers went haywire and their trades had to be cancelled.

But it is very easy to spot the problems. Correlation trading means that no individual market knows what it is trading. So the fundamentals of supply and demand become irrelevant.

Thus, as we are seeing to our cost today, oil prices continue to rise even though demand is falling. And investors think that the global economy must be doing well, because financial markets seem strong.