Fear The Uncorrelated Stock Market
Asset price correlations across a wide spectrum of industries and asset classes are meaningfully lower than the last few months. ConvergEx's Nick Colas note that this is something completely unexpected: we’ve approached a “Normal” capital market over the last 30 days.
S&P 500 sector correlations are below 80% relative to the index, foreign stocks are 77-87% correlated to U.S. stocks, and even domestic high yield corporate bonds are 56% dancing to their own tune.
However, before we run off celebrating the return to a stock-picker’s market, it is worth noting one statistical point worth your time: when industry sector correlations have dropped below 80% from 2010 to the present...
the subsequent one month, one quarter and one year returns have been below average, especially the shorter time frames.
Via Nick Colas, ConvergEx,
“Early is the same thing as wrong.” That’s another oldie-but-a-goodie from my library of ancient trader sayings, and I can’t help but think about it every time I see another high profile finance professional call a top to the U.S. equity market. The next day usually proves them wrong, and the next week confirms it, and the next month slams the last nail in the coffin of the prediction. You’d think that everyone would remember the mother of all bad “Get me out” calls – the Alan Greenspan “irrational exuberance” meme. He called the top of the domestic market in December 1996. About 1,000 days early.
At the same time, one understands the desire to make the call in the current environment. Stocks have more than doubled off the bottom, many investors have made a year’s worth of returns in the last three months, and despite lackluster U.S. economic data and troublesome rumblings from Europe, U.S. stocks basically just go up. As the poet Browning said, “God’s in his heaven – All’s right with the world.”
Perhaps the biggest surprise of all, although not as enticing as the “New high every other day” pattern, is that asset price correlations have declined to some of their lowest levels in years. Simply put, that means that capital markets are actually differentiating between health care stocks and emerging market equities. You’d think they would always do that, but since the Financial Crisis this has been a distinctly rare event. The whole “Risk on, risk off” theme has been a popular explanation of market behavior for a good reason – it has been largely true that all risk assets rise or fall together.
Until this month, anyway. Every 30 days or so we look at the asset price correlations for a range of industry sectors and different asset classes. We’ve been doing this for several years now, and the idea is to assess the health of the market in a more robust way that just saying “Stocks are up; everything is OK.” For a capital market to function properly, different investments have to move at different times. This allows for the benefits of diversification to offset the systematic risk of owning any one stock, bond, currency, commodity, or anything else. For this month, as shown in the accompanying tables and charts, the correlation news looks remarkably good. Here are our key points:
- The average correlation among the 10 different industry groups in the S&P 500 were 79% last month. That might sound high – common wisdom is that half of an asset’s move is typically due to the broader market – but compared to the last 2 months (85-88% correlation) it is fairly low.
- International stocks – both emerging and developed markets – are also showing more of a “Go your own way” level of price movement. Correlations for developed markets to the S&P 500 are 88%, versus 92% last month. Emerging markets essentially trade the same as last month, with a 77% correlation to US stocks (versus 78% last month).
- Domestic high yield corporate bonds have a current correlation to stocks of 56%, down from 75-81% two and three months ago.
There’s only two ways to read this data, and you have to choose one.
Behind door #1: After the better part of five years with investors clustering together for safety, we’re finally returning to a more normal capital market. Incremental buyers of risk assets are looking for actual outperformance versus their peers and the market as a whole. They are placing more aggressive bets, and this proactive attempt to outperform means asset prices are finally breaking out of their highly correlated patterns.
It is hard to overestimate how positive this outcome would be to stock markets around the world. The high correlation price action of the last few years may have generated some nice “New high” headlines along the way. But in reality, no one really cares. Asset flows remain weak, especially among retail investors as it related to U.S. stocks. But in a healthy market, where some groups just flat out trade better than others, some
Behind door #2: Nothing has fundamentally changed about how liquidity sloshes around capital markets, so any abnormally low correlations are likely a temporary anomaly. We pulled the prospective returns for the S&P 500 over one month, one quarter and one year for the 5 times average industry sector correlations dropped below 80%. You can see the dates and future market returns in the attached table.
The news isn’t good. Average one month returns when industry correlations drop below 80% are 0.02%, versus 0.90% for all months from April 2010 to now. Over one quarter, the S&P 500 returns (2.34%) after correlations get this low. The average for all months is positive 2.6%. For the following year, buying right as correlations hit their usual bottom results in an average return of 8.46%, or over 100 basis points less than the annual average of 9.8% over the period.
The bottom line is that we aren’t necessarily calling a top – that’s a fool’s game, as we noted up top. Still, the data doesn’t lie. Low current correlations seem to be a sign of complacency, similar to a low CBOE VIX Index. So celebrate a little, if you must. But drink in moderation.
and the relationship between the US equity market and the rest of the world has entirely decorrelated (left) as inidividual names in the S&P 500 have become the least correlated in over 5 years...