To all the other headwinds facing equity research, add the lockstep pattern of stock prices since the financial crisis. Why pay attention to research on individual stocks when all stocks move together? There are encouraging signs that five years after the crisis, the herd mentality is breaking down and individual stock picking is enjoying a renaissance. Long may it continue!
Prior to the crisis, most individual stocks were not highly correlated to overall stock market movements. Stocks in the Russell 1000 averaged correlations of 20-30% to the index during good markets and around 40% in bad markets. During the crisis correlations increased to 50-60% and stayed there. Now there are signs that correlations are beginning to drop, having fallen in the last year to around 30%.
The highly correlated “Risk on/Risk off” markets have been positive for macro-economic research and investment strategy firms, which look at the big picture. They have been difficult for fundamental research and most other types of investment research which provide insights on individual stocks.
In his second quarter investor letter, small cap manager Chuck Royce noted the change in market tone remarking that the “the second quarter offered a more eclectic, and thus encouraging, mix. Within the Russell 2000, both Consumer-oriented sectors remained strong, as did Health Care, Information Technology, and Telecommunication Services… The S&P 500 showed a similarly scrambled pattern among large-cap sector returns. Although painful in the short term, we see this growing differentiation as a very positive sign that the market is beginning to break out of its correlation groove.”
Evidence of change
ConvergEx Group chief market strategist Nick Colas finds that correlations have receded not only between stocks but also between stocks and other asset classes. High yield bonds are only 16% correlated with the S&P 500, down from 66%. Emerging market stocks are down from 80% to 56% correlations to the S&P 500. The best news for stock pickers, however, is his measurement of the correlations between stocks:
The 10 industry sectors of the S&P 500 currently show the lowest average correlation to the broad market of the last several years. Last month this number was 70% – the month before was 89%. More surprising is that the selloff of the past week didn’t shift this number higher, as it has done in every market decline since 2008. As for specifics sectors, tech stock correlations to the S&P 500 are down to 58% from 92% last month and Utilities sit at a 47% correlation down from 75% the prior month.
Citigroup equity strategist Tobias Levkovich believes that falling correlations signal that a correction is ahead. He noted that the correlation between the top 50 market cap names and the overall market has plunged from 66% at the end of June to just 18% at the month’s end in July, warning that low levels suggest a degree of complacency that puts fund managers at risk for a correction.
After five years of highly correlated markets, no one is comfortable declaring a permanent return to less correlated markets. As Colas says: “It could all just be a fluke.” Nevertheless, the prospect of an end to the U.S. Federal Reserve’s policy of quantitative easing has roiled bond markets and is at the core of the correlation shift. The end of quantitative easing will not be a bed of roses for the stock market, but if it results in a less correlated market it will ultimately be positive for most equity research providers.