Via ConvergEx's Nick Colas,
Our monthly look at asset price correlations finds it’s getting just a little bit easier to beat the U.S. stock market with savvy sector bets. OK, not by a lot: average correlations for the 10 sectors of the S&P 500 to the index itself are down to 79.9% versus the year’s typical reading of 80.7%. The best hunting grounds have been in Technology (84.9% correlation, down from +90% the last three months) and, surprisingly, Utilities (32.9% correlation, down from 47-77% in the last three months). Both have beaten the overall market over the last month as well. Looking forward, the quickest way to even lower correlations (which are good for active managers and passive investors alike) is for the Federal Reserve to move on rates sooner rather than later. By our reckoning, the currently still-high correlations show that markets don’t quite think the Fed is moving in September. If they did, correlations would be dropping more quickly.
In my 25 years doing just about every job in finance I have had the chance to meet a wide array of money managers. This experience has taught me that there are only three kinds of people that can reliably “Beat” the market once you put aside obvious inputs like competent risk management and a stress-resistant personality. These are:
The savant. There is a certain type of person that can read price movements and consistently extrapolate signal from noise. You could plop them on a desert island with little more than a Bloomberg machine, some dip, a Chinese takeout menu and some way to make trades and they would still make money. A lot of it. They tend to read to the New York Post, never miss a free meal, and will die between 4pm and 9:30am because during trading hours nothing will deter them from seeing the close.
The information hound. This breed makes it their business to know every single important source of knowledge about the companies in which they invest. They don’t know everything, but they know where to find any piece of information necessary to price a security. Twenty years ago this type of investor visited every single company they followed every quarter. Now, they do that AND they hire satellites to fly over production facilities AND use online tracking software to monitor company fundamentals in real time. Effective activists fall into this camp, by the way.
The big picture thinker. Some people are just better than the population as a whole at assimilating large quantities of information and synthesizing it into profitable action. The advent of computerized trading over the last decade has pushed a lot of these individuals into routinizing their approach into systematic algorithms, of course. But the best of the bunch see linkages through the capital markets the way spiders feel their webs – in analog waves, not digital bits and bytes. If the butterfly flaps its wings in Thailand, they know to get short insurers in Texas.
All three types of investors/traders need the same thing to deliver the best results: asset prices that move at least somewhat independently of each other. After all, their special set of skills is in separating the wheat from the chaff, the good from the bad, or the stars from the airplane lights. The more those differences cause divergent prices, the higher the potential profit. For example, consider the S&P 500 – how many names in this index are up more than 20% on the year? The answer is 70 by our count, or just over 1 in 7. Only one name is a clean double in 2015: Netflix. Conversely, there are 60 names in the index that are down more than 20% but only three – Freeport-McMoRan, Consol Energy and Chesapeake Energy – are down by 50% or more. That leaves 372 names in the S&P 500 in a performance band of +20% to -20%. Close down the range to +10/-10%, and we count 197 names in that range. That’s 40% of the entire S&P 500 clinging to a pretty narrow band around the “Unchanged on the year” line.
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Another way to consider the question of how much opportunity there is in the S&P 500 and other asset classes is to look at stock price correlations – how much the individual sectors of the index move in tandem with the market as a whole. We look at this data on a monthly basis, and there are several tables and charts at the end of this note. Here’s our summary of this month’s numbers:
The average price correlation of the 10 sectors of the S&P 500 to the index was 79.9% last month. On the good news front, that’s less than the YTD average of 80.6% so asset prices have been moving a touch more independently over the last 30 days than the year as a whole. As for the bad news, that’s still far higher than the textbook 50% correlation a sector “Should” have to the market as a whole.
The two standout sectors last month were technology and utilities. Tech saw its correlation to the S&P 500 drop from 93.4% to 84.9% and the group also outperformed the broad market (+1.8% versus 1.1%). The utilities group, left for dead on the thesis of ever-rising interest rates, also outperformed last month (+3.3% versus 1.1%) and managed to cut their correlation to the market to 32.9% from 47.6% at the same time.
Emerging markets had a tough time over the last month, down 7.9%, but as any trader will tell you the moves between the U.S. market and far flung bourses were tied at the hip. As a result, the correlation between the two was quite high – 71.7% - but no higher than the last few months combined. Developed markets, as represented by the MSCI EAFE (Europe, Asia, Far East) index also showed high correlations to the S&P 500 at 83.6%.
Correlations between the high yield corporate bond market and equities have been tightening up over the last three months, an unwelcome development for those who worry about the structure of that market if general asset price volatility picks up. Correlations between “Junk” bonds and U.S. stocks were 66.5% last month, up from 55.7% the month before and 49.7% the month before that.
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Gold has been a brutally tough investment over the last month, sinking to multi-year lows. The best thing you can say about this trend is that at least the yellow metal still hews to its own path. Correlations to stocks here were -25.3% last month.
Now, the #1 question we get after we review correlations every month is “Why are they so high relative to long term historical norms?” Our answer is that Federal Reserve policy has been an unusually important factor in asset prices since 2009. The unusually easy monetary policy since that time (and its planning, implementation, and effect on the economy) has been a powerful unifying story in capital markets. Now, as the Federal Reserve moves to return the economy to a more “Normal” policy stance, correlations should drop. That they have not yet moved convincingly lower is a sign that equity markets may want to see the Fed actually pull the trigger.
