Beware of your residuals

In the past year, the correlation in daily returns between the S&P 500 and S&P Europe 350 is 0.92.  During this period, the S&P Europe 350 has declined 19.5%.  Given this very high correlation, where would you expect the S&P 500?

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Of course, the S&P 500 is actually up 3.8%.

Within the residuals, just 0.076, there is a 23.3% difference in performance:

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If you had shorted US equities understanding this correlation was very high, and thinking European equities were going to fall, you’d probably be rather disappointed now.

What we see here is that the price of liquidity is shared by both European and US equities, but the valuations clearly are not.

We’ve used the Asian Financial Crisis as an analogue in a few past articles.  To draw the example:

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View how correlated Asian market were in particular during the heat of the Asian Financial Crisis, but yet how dispersed the outcomes ended up being.

Increasing correlation amongst markets is likely a reality given a more synchronised business & policy cycle.  But that doesn’t mean the outcomes in their stock markets will even be remotely similar.

Beware of even your small residuals.  That’s where the last 23.3% alpha was hiding.  Think about the next time someone makes a bearish case on US stocks on the basis of European economics.

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3 Responses to Beware of your residuals

  1. as says:

    hi, you are using misleading numbers. you are using the ETFwhich includes the impact of the EURO which is down 15% for that period. stand alone the index is down closer to 5%. When you do a correlation analyis between S&P and Euro 350, it is only about 70%. when you do the ETF (which is translated to $),it jumps to the 90s.Thx

  2. Matt Busigin says:

    Not only is the fact that IEI is denominated in USDs not ‘misleading’, it supports my argument.

  3. Lee says:

    Hi Matt,I’m interested in speaking to you about your content. Please contact me at lee AT forexpros DOT com. Thank you, LeeAbout Us Founded in 2007, Forexpros is a definitive source for tools and information relating to the financial markets such as real-time quotes and streaming charts, up-to-date financial news, technical analysis, brokers directory & listings, an economic calendar, and tools & calculators. The site provides in-depth information on Currencies, Indices & Stocks, Futures and Options, Commodities, and Rates & Bonds. With a growing readership worldwide, Forexpros is a leading global financial portal that is constantly committed to launching innovative features and sections to ensure an optimal one-stop source for its readers.

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