A Visual Aid to Trading

 | Apr 07, 2014 | 12:00 PM EDT
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This morning's action looks textbook. It will be interesting if it doesn't hold, but the push lower after a weak Friday was actually what the bulls wanted, nay, needed. Although only the Q's have peeked into the green, a push higher today will get some folks talking about the "V" bounce again. If that's your game, look at oversold areas like technology, small-caps and biotechs. However, a failed bounce today will bring on much more pain this week. Turnaround Tuesday may become more like tumultuous Tuesday.

When we have these bumps and bruises, it brings to mind diversification. Jim Cramer has done a great segment on "Mad Money" with the "Am I Diversified?" concept. Of course, not everyone has the time to go piece by piece through a portfolio when things get bumpy. I've found a great way to start is visually. Many traders and investors are visual learners. If you are a technical-analysis person, then you are certainly a visual learner. If that's you, here is a simple trick to get you started.

I'm going to stick with basics here using exchange-traded funds, but a person could easily punch in a group of four or five stocks here. All I've done is chart the price action of several popular investments like the SPDR S&P 500 (SPY), iShares Russell 2000 (IWM), PowerShares DB10 Currency Harvest (DBV), iPath Short Term VIX Futures (VXX) and Barclays 20+ Year Treasury Bond Fund (TLT). This part of the chart gives me a quick glimpse into the price action. For instance, it is obvious how the SPY and VXX diverge from each other. What isn't so clear is how the others move in relationship to the SPY. This is why I include the correlations of each security to the SPY below the price action chart.


Daily Correlations
Source: StockCharts.com



Weekly Correlations
Source: StockCharts.com


It is clear over the past four months that the IWM and SPY run in a very high correlation. Note that correlation has waned a bit over the last two weeks. Ironically, the market started to push lower about a week after that correlation faded. It is also clear that mid-term (7 to 10 years) and longer-dated Treasuries (20-plus years) have a correlation that rotates between a strongly negative position to one of no correlation. It is somewhat similar to VXX, although that is consistently a strong inverse correlation.

This is a great place to add random concepts. Utilities might be one to include, but I added the DBV. I was surprised to see the consistent positive correlation for the past four months. Additionally, it was quite high for much of the time.

After getting the basic concepts from the daily chart, I will expand the correlations out to a weekly chart and compare the results. Again, the IWM runs with a very high and very consistent correlation to the SPY. Investing in the SPY and the IWM doesn't provide much in the way of diversification. Common sense? Probably, but it's still good to examine the relationship. There really isn't much change in any of the correlations except on the DBV. The weekly chart demonstrates it can run from high correlated to moderate inverse correlation. That's actually a positive to me as it means there is a good chance DBV will at least offer longer-term diversification for a portfolio.

After a first run like this, I will then remove anything that looks too similar and look for replacements. For instance, I would probably look to drop IWM and likely iShares 7-10 Year Treasury Bond (IEF) as it is too like TLT. I then might look to test something like the SPDR Utilities (XLU), SPDR Gold Trust (GLD) or some emerging market mix of securities and debt. These charts make for a great starting point, which is sometimes the hardest thing to find. They also can act like a good sell signal. If your correlations start running too high across many of your holdings, look to peel some off and get back into a more diverse portfolio.

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