HOW CORRELATED ARE NIFTY STOCKS?

 

Source : Aaron Bacall The New Yorker Collection/The Cartoon Bank

 

In any portfolio diversification is essential. How does one go about it? As long as an investors portfolio consists of companies whose businesses are not correlated, diversification is possible. The idea behind having a diversified portfolio is primarily to reduce risk. The reason is that, since the businesses are not correlated, when one company is doing well the other is likely to be doing poorly. This correlation ensures that the Nifty is ‘balanced’ on a daily basis. There is an Index management methodology (adopted by Index funds) which is clearly visible and evident. Many a time, on days when most sectors are negative, one of the sectors which is the least correlated with the Nifty tends to spike, restoring partial parity to the index. When this does not happen, there is a huge one-sided move.  Hence, the question of whether the Nifty and the stocks contained therein are correlated. The CNX Nifty represents roughly 65 % of the free float market capitalisation of the Indian stock market. Its sectoral composition is shown below:

SECTOR	WEIGHT(%)
FINANCIAL SERVICES	28.34
IT	15.21
ENERGY	15.01
CONSUMER GOODS	10.53
AUTOMOBILE	8.8
CONSTRUCTION	5.8
METALS	5.62
PHARMA	5.17
CEMENT & CEMENT PRODUCTS	3.08
TELECOM	1.56
INDUSTRIAL MANUFACTURING	0.88

It must be remembered that, when there is a recession all companies end up doing badly. In spite of this,  it has been found that stocks are correlated. The degree / magnitude  of correlation varies across time spans, and depends on the underlying economic conditions. In India we do not have a correlation Index, as yet. Also, increased market volatility leads to heightened estimates of stock correlation, even when there is no change in the underlying performance of the stocks. All stocks moving in unison means that correlation is close to 1. This is more pronounced on the way down. What matters to most investors is not whether stocks move up in unison, but the magnitude of the move.The stocks which move against the market  (i.e. they move up when the market moves down and vice versa),  are said to be inversely correlated with the benchmark and vice versa. This is what the Modern Portfolio Theory (MPT) says.

The Modern Portfolio Theory

This theory was invented by Harry Markowitz, and for his contribution he was awarded the Nobel Prize in 1990.  The theory talks of correlation coefficients of different stocks. The higher the correlation the less chances of achieving a diversified portfolio.    The table below shows this:

CORRELATION COEFFICIENT	DIVERSIFICATION OF RISK
+ 1	NO RISK REDUCTION IS POSSIBLE	PERFECT POSITIVE RELATIONSHIP
+0.5	MODERATE RISK REDUCTION IS POSSIBLE
0	CONSIDERABLE RISK REDUCTION IS POSSIBLE
-0.5	MOST RISK CAN BE ELIMINATED
-1.0	ALL RISK CAN BE ELIMINATED	PERFECT NEGATIVE RELATIONSHIP

 

The salient points of this The Modern Portfolio Theory are:

1. The theory, in a nutshell, says that portfolios of risky stocks might be put together in such a way that the portfolio as a whole could be less risky than the individual stocks comprised therein.
2. As long as there is some degree of parallelism in the fortunes of the individual companies in the economy, diversification can reduce risk.
3. Moreover, since companies fortunes don’t always move completely in parallel, investment in a diversified portfolio of stocks is likely to be less risky, than investment in one or two single securities.
4. The premise of the theory is that all investors are risk averse. They want high returns, guaranteed outcomes and no risk. The theory tells investors how to combine stocks in their portfolios so as to give them the least risky portfolio.
5. The theory is basically based on the maxim that a diversified portfolio is likely to give a higher return as compared to one which is concentrated in select stocks or is not diversified.
6. Historically it has been proved that in all situations, other than those in which there is perfect positive correlation it is possible to reduce risk. In short, an analysis of the correlation coefficients of securities in a portfolio can reduce the overall risk of the portfolio.
7. In effect, diversification is like a magic pill, higher returns with lower risk.
8. As markets mature, the correlation has been moving higher internationally. In spite of this markets and stocks inter-se are still far from perfectly correlated.

In the context of the Indian market, correlation coefficients are published on a monthly basis by the NSE. We have to assume the correlation coefficient of Nifty as being 1.  In comparison to this, the higher the correlation coefficient (closer to 1) the higher the correlation and vice versa. The inter-se correlation between different sectors of the Nifty are more relevant in deciding stock returns, as compared to interest rate changes and forex. All sectoral indices have a more than 60 % correlation with the Nifty. What is interesting is that even though all sectoral indices are directly correlated with the Nifty the inter-se correlation among the sectors throws up opportunities of portfolio planning, hedging and paired trades.

In the context of the current market scenario, I proceeded to analyse the correlation between Nifty stocks for the period July 2013 to June 2014. The following are the pairs which are inversely correlated. I have also included a column showing the number of months in which this inverse correlation is seen. It must be remembered, that in the period selected the market as a whole has moved up, hence there are not many instances of ‘inverse correlation’.

 

SCRIP	SCRIP	NO OF MONTHS
INFY	ITC	8
HCLTECH	HINDUNILVR	8
SBIN	TCS	8
ASIANPAINT	TATASTEEL	7
BHEL	CAIRN	7
BPCL	CIPLA	7

 

 

How is the Banknifty correlated with the other stocks?

 

In a research paper published by the Indian Journal of Research, a comparative study of the Bank Nifty and other sectoral Indices of  NSE was published. The study examines the relationship of the Bank Nifty with the other sectors. This is divided in to the bull phase and the bear phase. I have relied on the same and the salient points are.:

1. It was found that the banking sector contributes the most to Nifty returns.
2. There is, after that a significant correlation between the other sector returns and Nifty returns.
3. In bear phases, it was found that the Bank nifty and all other sectoral indices are positively correlated, except the pharma sector.
4. In bull phases, it was found that the Bank Nifty and  all other sectoral indices are positively correlated, except the realty sector.
5. The FMCG index is the least correlated with other sectoral indices.
6. Hence, the Bank Nifty effectively influences all sectoral indices. Investors would be well advised to study the movements of this sector before deciding how to invest.
7. Using this data investors who believe in hedged strategies can pair their trades.

Some of the observations are debatable, but then that is what the markets are all about. Broadly I think the observations are correct.

Conclusion

 

Why is it necessary to look at sectors? Many investors buy into sectors when they are hot, and soon they are as cold as ashes. This is exactly what has happened in our market in the last 45 days. The secret is to do the opposite of what most fans of a sector are doing. In the market some sector is always hot, it is usually the sector which is the most under-owned. Buying the hottest sector is usually a strategy investors adopt to get rich quick, it usually results in getting poorer, even quicker. This sectoral cycle is ongoing,  irrespective of whether we are in a bull market, bear market or a sideways market. Looking at correlation ensures that all parts of your portfolio don’t tend to go up and down together. Sectoral investing is a diversification tool.  My own experience with diversification is mixed, since every time I have tried to diversify, I have ended up di-worse-ifying.  In any case, investing money by having a diversified portfolio is always a better strategy. Despite all these diversification theories, there was no place to hide in 2008!!!!

 

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