When Declining Correlation Meets Rising Volatility

This Market Review was originally published at socialLeverage50.com on Jan 18.

The best (biotech, solar, cloud) and the worst performers (gold and silver miners) from last year are shining in early 2014.

The long bond ($TLT) is rallying all of the sudden. Is it a sign of people getting more defensive.

The S & P 500 lost 27 bps for the week, but under the illusionary calm surface, there was a lot of action. The SL50 list gained 1.19%. It was up more than 2%, before it pulled back on Friday. High-growth, high-beta stocks are leading indicators and we judge risk appetite based on the action in them. It has been a stock pickers’ nirvana with incredible opportunities on the long and on the short side.

We are seeing a huge uptick in volatility and drop in correlation at the same time. The drop in correlation is a positive sign and often a natural side effect of entering into earnings season. The uptick in momentum stocks’ volatility is a warning and usually a precursor to a market pullback.

The initial reaction to earnings reports indicates that this market will be merciless to missing estimates.

There has been notable relative weakness in consumer related stocks – save for $AMZN, retail stocks have been hit with a shovel in the head. Now, restaurant stocks are also starting to show signs of deterioration.

The biotech sector ($IBB) is over-bought and it is very likely to consolidate through time or price in the very near-term perspective. Where will the new leaders come from?

The first reports from the financial sector have not been inspiring and the averages continue to consolidate through time. Semi-conductors attempted to take the lead, but were shot down by a weak Intel numbers on Friday. Nevertheless, there are some very noteworthy developments in the sector and major positive price action to pay attention to: $INVN$SWKS.

Chinese and U.S. Internet stocks continue to deliver for the most part. The big picture catalyst is clear – no matter what happens with the general economy, the Internet sector is likely to continue to grow. Everyone knows that and it might has already been discounted in a way. During general market pullbacks these stocks will hardly remain impenetrable fortresses, but dips there will be most likely welcomed as buying opportunities.

Marketing svs stocks have been on fire as corporate America might be finally ready to open its wallet and spends some its cash: $FUEL$MKTO$CTCT.

Another industry that is a candidate for the biggest surprise of 2014 is education svs. Highly shorted, and hated, vulnerable to disruption from the new app world, yet near 52-week highs and gaining momentum. These were some of the major characteristics of solar stocks in 2013 and homebuilders in 2012. There are no education svs stock on the SL50 list, but we are keeping a close eye on the industry: $APOL$CECO$ESI$EDU$XUE, etc.

Earnings season has just started and over the next month thousand of companies will report earnings. By default, the SL50 list rebalanced once a week, so we will likely see gaps in both directions as always. In a good market, the upside gaps are a lot more as even “bad” news is “good” and surprises tend to follow the direction of existing trends. In a deteriorating market, we see a lot of negative gaps among momentum leaders, which is a major leading sign of risk appetite reduction.

We are seasonally in a strong period for the general market, but this does not guarantee that we cannot see a 10% pullback and maybe this is exactly what the market needs to shape up some new, good risk/reward opportunities. For swing traders, it makes sense to decrease your position size a bit here.