ETF Trading with Larry Connors: Do Correlations Hint at Further Selling?

Here’s the backdrop coming into today.

Bloomberg published this last night:

1. Stocks in the S&P 500 are moving in lockstep with each other by the most since at least 1990, a sign that the market’s biggest retreat in three years may not be over, according to MF Global Holdings Ltd. The average correlation coefficient between the 500 companies and the index was 0.8268 on Aug. 18, using 60 days of data, according to MF Global.

Correlation among S&P 500 stocks exceeded 0.78 twice previously, according to MF Global. After the first time, on Dec. 1, 2008, the S&P 500 declined 17 percent to a 12-year low on March 9, 2009. Correlation peaked again on July 26, 2010, when the benchmark slipped 6.1 percent over the next month.

2. This weekend’s Financial Times reported that hedge Funds are beginning to aggressively put on short positions. The Data Explorers Long/Short Ratio for U.S. equities has shown a healthy decrease in the ratio (meaning the level of shorting has increased). Many of the hedge funds are reversing their positions and are now the most bearish on U.S. equities since May.

Obviously each of these reports is after the fact. Prices are now down over 15% in a few weeks, the level of fear in the market is at the highest it’s been in in three years, and you couldn’t find a positive story published anywhere this weekend.

Adding all this together, it says that a short-term rally is likely very near and the rally could be substantial. Everyone who has sold has sold and is waiting to get back in. A gap higher (possibly today as futures are higher right now) could create the beginning of some buying which may turn into panic buying (with a lot of short covering).

When you look at big cap, low-priced stocks like ^F^, ^AA^, ^AMD^ and ^DAL^, all selling at least 20% off highs, you have to imagine that the institutions are going to come into these stocks. None are going out of business and many just showed solid quarterly earnings. Even though each is under their 200-day ma (about 90% of the liquid stocks are), money is going to find their way into them very soon.

As was mentioned last week, the path of least resistance is down but it doesn’t go straight down. Bounces occur and bear market bounces can be substantial. I wouldn’t be surprised to see one very, very soon.