For inter-market correlations I refer you to a great post by Brett Steenbarger which discusses current inter-market themes.
As for intra-sector correlations, anyone who has been following the market the past couple months has certainly noticed that the banking industry has quickly become a very good short term metric for the health of the overall market. Not surprisingly both the volatility and severity of movement within the industry (KBE etf) has increased significantly as the index’s components get crushed on down days and spike up when we see optimism in the broader indices. I have also noticed qualitatively what seems to be a much greater correlation within the 24 components of the KBE etf along with fewer sustained countertrend divergances from the overall industry trend on an intra day basis.
above is a weekly chart of the KBE etf and the average true range over that time which illustrates the significant rise in intraday volitility.
These observations gave me the basis for the system I am currently testing. My working theory is as follows:
The current fears of CDO write downs, counterparty risk, capital ratio’s and the opacity of bank balance sheets have caused many short term investors to treat all banks as one in the same, especially during intraday sell offs and rallies. This increased correlation if valid should cause short term counter trend price movements of the etf's components to have a greater probability of reverting back to the overall trend of the etf. My intention is to identify these countertrend price movements and then enter trades (either long or short) that would profit from the reversion to the mean.
This weekend I will post some of the statistics of my findings and how I plan to identify and profit from the previously mentioned price movements.
Andrew
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