What investors need to know about market correlation

1st August 2012

In stock dealer jargon, these markets are showing correlation. When one market rises, the others do the same and vice-versa. The same applies to individual stocks – banks will tend to move in unison showing high correlation because it can be difficult to differentiate between banks while pharmaceuticals will show a lower correlation as each can have varied factors such as the number of new drugs in the pipeline or old medicines going out of patent.

But once investors notice that this correlation is easing, that there is more differentiation both between indexes and their constituents, it could be a sign that equity prices are ready to soar.

Understanding the correlation numbers

First some basic maths.  An index pair or stock pair that moves exactly together has a correlation of 1.0. A lower number implies less togetherness while a negative number would imply that when one rises, the other falls. Where assets are correlated, it is difficult to create diversification between them.

A recent Global Strategy Paper from investment bank Goldman Sachs notes that while correlations across equities are not as high as during the height of the 2008 financial crisis, they "remain elevated compared to long term averages."  Although it has come down since, in October 2011, correlation within the Standard & Poors 500 hit 0.9 – the highest level for 23 years.  Or  as this Marketwatch article states with much the same conclusion, correlation is "as high as an elephant's eye".

World equity markets are dancing to the same tune and within these markets, individual equities also tend to move together as if choreographed. 

High correlation is generally a bearish signal.  It means that investors are not relaxed enough to look at individual markets, let alone the merits or otherwise of each equity. They are too fearful to look at equity diversification, preferring to spread their risks with cash or bonds, even if these are negative after inflation and present greater currency risk than many global companies. They are into a "macro-market" where individuality is absent. 

Stockpickers out of a job

Stockpicking has to take a back seat as markets over the past five or so years have been driven by big picture factors.  Goldman Sachs says "with higher correlation of equities, the dispersion of results within a market declines and the "alpha opportunity" [the chance to outplay the index tracker fund] is smaller as a result. Stockpicking is more difficult with elevated equity correlations."

Correlations are similar to volatility – both increase as result of investor fear.

Now for the chicken and egg bit. Goldman Sachs analyst Christian Mueller-Glissmann cites the increasing popularity of index funds and exchange traded funds based on indexes as one reason for correlation increase. Investors in these vehicles do not look at individual stock prospects. But is this cause of correlation or a symptom or reaction to it?

There have been substantial structural changes in markets.  The FTSE Index, for instance, has fewer links with the UK economy than when it was first set up nearly three decades ago. Emerging market economies are more important. Companies – especially large capitalisation ones – have become more international.

 

Passive soars in popularity

At the same time, cost factors have increased the popularity of passive investing including equity ETFs. Since 1995, passive has soared from five per cent of assets under management to over 25 per cent. These are more likely to be driven by macro factors.  The chicken/egg question is how far this trend has been forced on investors who believe low cost passive investing can produce superior returns to stock-picking or how far this is a risk-averse reaction to the high equity risk premium. 

When the premium is high, investors have lower confidence levels and expect higher returns leading to individual equities becoming more sensitive to changes in analyst forecasts, missed targets, economic shocks, and the general newsflow. This has led to the simple mantra of "risk-on, risk-off" in investment as investors shift equity risk to non-equity assets, such as bonds, cash or gold, and back again.

Stock-pickers are out of fashion. If all stocks move more or less together, what is the point? How can you generate alpha when everything tends to beta?  Hedge fund managers with equity long/short mandates have to select shares that will either go up or down by more than the market as a whole. They have struggled to perform.

Euro index signals negative

One way of gauging market sentiment is to look at derivatives which price correlation going forward. The Euro Stoxx 50 Index  correlation over the next 12 months is currently at very high levels. Options on this index are used by traders because both it and the underlying single stocks have sufficient liquidity.

But it will not remain there forever.  And once the correlation number starts to crumble, it could be a buy signal for equity fans as well as a green light for stockpickers as an article in Barrons argues. opportunity in stocks.

It warns: "Lockstep trading in stocks is the clearest evidence that corporate fundamentals are being ignored and traders are dumping good stocks along with the bad."

It quotes Nicholas Colas, a strategist at ConvergEx Group who views very high correlation as a buy signal. "Intuitively, extreme correlation indicates traders have become indiscriminate, usually by selling heavily. That's why the phenomenon can be mined for sentiment, much like sovereign-bond yields, credit-default swaps, or volatility indexes are. It's one of the symptoms of capitulation, right now, the signal is high but not extreme, a cautionary signal. But it wouldn't take much to push correlation further."

Investors cannot expect correlation to disappear overnight. But if and when it starts to crumble, equity buyers will see it as a buy signal.

 

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