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A Possible Leading Indicator Of Bear Market

A recent rapid decrease in the correlation of Dow Jones Industrial Average components with the index itself could be a leading indicator of a bear market as this has also occurred in the past around the 2000 and 2007 tops.

Recently I have noticed deterioration in the correlations of a number of Dow 30 stocks with the index. These are correlation of returns, not prices. Although the index has recently completed a 28-day streak with Relative Strength Index (RSI) above 70, some key components were either flat or on a short-term downtrend, including CAT, CVX, DIS, GE, PFE, PG and VZ.

Obviously, correlation does not imply any form of causation and on top of that the market is known to deliver blows to naive attempts to time tops but the recent decline of correlations to levels that were observed before or near the two last major corrections is interesting and should be taken into consideration.

Below is a table of 0-lag 120-day correlations between nine Dow 30 stocks and DIA ETF. These correlations are at low levels compared to past and longer-term averages.

Source: Portfolio Visualizer

Below are the charts of the rolling 0-lag 120-day correlations of returns between the nine stocks and DJIA index.

Let us look at PG for example:

The 0-lag 120-day correlation of PG and DJIA returns is at +0.14, down from about +0.80 in February of last year. The stock made a new all-time high about two months ago on September 20 and since price has corrected. The correlation is now near levels seen before the 2000 top. This is a low correlation for a component of an index that is up 18.6% year-to-date. Year-to-date return of PG is about 9.2%.

Another example is DIS, up only 1.3% year-to-date. The correlation is now near levels seen before 2000 and 2007 tops, as shown in the chart below:

Again, correlation does not imply any causality. An index can rise although correlation with components is low because of occasional price spikes due to earnings releases, fund buying and central bank manipulation of asset prices. Nevertheless, these decreasing correlations are worth noticing.

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Charting and backtesting program: Amibroker


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