Peer correlation: The influencer to watch

25 July 2017

By Cory Todd

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Looking to your peers to better understand your own stock has never been more critical. The information gained from analyzing volumes, trends and performance of peers directly ties to the same measures in your own stock.

And while most IROs look to peer trading for insight into performance, I wonder if they’re looking to the right peers, or if they know how often their peer list changes and evolves as the company grows and morphs? While peers don’t change on a daily basis, over the long haul just as a company changes, so must the peer list.

We find that looking at the correlation between stocks can be a helpful tool when identifying one’s true trading peers. Correlation, dissected down to its most rudimentary level, means: a mutual relationship or connection between two or more things. While a somewhat simplistic definition, correlation is the basis for billions of dollars of investing and the backbone for many hedge fund and quant-driven strategies. The information garnered from these relationships can be extremely helpful in understanding the driving factors behind a given security.

Wall Street uses correlation in a multitude of ways. Some money managers view it as a means to measure their market exposure. Utilized in this context, correlation can provide a better understanding of risk by measuring how connected stocks, and even entire portfolios are to one another. Correlation is also used as a hedging mechanism, used by many traders as the mainstay for their entire trading strategy. In a simplistic pairs trading example, a trader would buy one stock and sell another highly correlated stock with the expectation that the one they own would outperform the shorted one. Trading like this has been around as long as the market. Every sophisticated trader will use correlation at some level to manage risk or understand their portfolio’s true exposure.

 

The impact on public companies

Correlation matters for IROs for the same reason as traders: stocks your company are most correlated to are key drivers to your own volume and performance. The higher the correlation to an individual stock or sector, the higher the spillover volume and performance will be. By understanding and monitoring these relationships, IROs are better able to determine the underlying drivers, and their various impacts on their company’s shares.

The following Q4 Desktop screenshots illustrate the relationship between two companies and the impact of correlation. Parkway, Inc. (PKY), a real estate trust, released positive earnings last month. At Q4, our quantitative analysis showed that the “stock-specific” impacts of trading (i.e., order flow intended to buy PKY shares alone, and not part of a hedge or sector/market exposure) accounted for all the gains in their shares following the bullish earnings report. The mirror impact, however, was felt in its most highly correlated peer Mack-Cali Realty Corp. (CLI). Again, based upon our quantitative analysis, one can clearly see that CLI’s shares actually saw “stock specific” selling based on the PKY news (possibly a pairs trade with investors going long PKY and short CLI, or potentially a rotation out of CLI and into PKY). It was due to CLI’s correlation to its peers and the broader market that its overall losses were curbed.

 

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Correlation is not a stagnant thing

From a trader’s perspective, the more stable a correlation, the easier it is to use in risk management. But in reality, companies are always changing — and so is Wall Street’s perception of a company. What was once a sector’s “hot stock” will eventually fizzle out, and likewise, what was once the “black sheep” may become the next high-flyer.

Because of the myriad of variables in the marketplace, correlation is not constant. This is why IROs need to monitor how their company’s  peers are changing and evolving over time. Not necessarily on a daily, or even weekly basis. But it should certainly be a part of the analytics and KPIs being watched — keeping a keen eye out for major shifts in particular. Companies grow and behave differently over time, and because of this what were once “perfect peers” from a correlation standpoint shift. Additionally, divisions within a business that were once secondary drivers can become a more primary focus of outside investors. With that kind evolution, the stocks you are most correlated to will likely change as well.

If we stick to PKY as our example company, we see its three most highly correlated peers change over time.

 

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Over the past three years, we see the top relationships for PKY shifting rather dramatically.  Only two names are repeated as a top three peer. This further illustrates that companies should monitor not only the trading in their peers, but also who their “true peers” (those companies that are most highly correlated and influence trading in your own company’s shares) are. A stagnant list will provide IROs with misinformation and wrong assumptions as to what is driving volume and performance in their own company’s shares.

 

With the advent of robo investing and algorithmic trading, looking at relationships between stocks, sectors and the overall market has never been more crucial. Volume and performance is tied between correlated products more today than ever before. It’s important to constantly be examining those relationships and questioning the driving factors behind them to gain the full understanding as to what is moving your stock. Peers from a year ago, may not be the peers of today. The company you are today, may not be the company you were a year ago. It’s through constant analysis one can stay ahead, and prepared to answer the question at any given moment: Do you know who your peers are?

 

Cory Todd is the vice-president, quantitative analytics at Q4.

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