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Technical Analysis

The Collapse of Correlation of S&P 500 Index With Equal Weight

Yesterday some traders pointed to a chart showing a drop in the correlation of S&P 500 index with its equal weight variant to levels realized near the 2000 top.

This is the chart: 0-lag, 250-day correlation of daily returns of S&P 500 index and S&P 500 Equal Weight index.

The 250-day correlation dropped from an average of 0.97 to about 0.85 and as marked on the chart this is below the level reached at the 2000 top formation.

What could this mean? Is this a technical signal of a major top?

Notice how during the 2007 top a similar drop in the correlation was not realized so a collapse in correlation may be sufficient for a top but not necessary.

But as I have argued in my book Fooled by Technical Analysis, indicators of price are neither necessary, nor sufficient for price action. One reason for that is the small sample. We do not have large enough samples to draw any statistically significant conclusions. This is just a sample of one event.

Below is what happens if we consider instead the correlation of S&P 500 Total Return index with S&P 500 Value Total Return Index.

The correlation dropped in 2006 from an average of 0.96 to less than 0.7. That was an even more severe collapse. But the market continued rising for more than two years. Then, a technical analyst that relies on a sample of one could claim that according to this chart, stocks can still go up; or that after two conflicting signals, there is no conclusion.

The correlation collapse is just another of hundreds of charts that supposedly signaled a major top in the last few years. Eventually a top will be formed, some chart will be right and an impression will be left that charts can predict tops. The reality is they cannot.

Disclaimer:  No part of the analysis in this blog constitutes a trade recommendation. The past performance of any trading system or methodology is not necessarily indicative of future results. Read the full disclaimer here.

Charting and backtesting program: Amibroker. Data provider: Norgate Data

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