Two Ways to Play If Stock Correlation Continues to Decline

By Wayne Ferbert  SEP 12, 2012 11:20 AM

Profiting from the correlation of the top 10 S&P 500 sectors to the broader S&P 500 Index.


One of the most important articles I read in weeks was on the blog on the Wall Street Journal yesterday. It was about the correlation of the top 10 S&P 500 sectors to the broader S&P 500 Index (^GSPC). Correlation reached a very high level in July and August of this year. Here is an excerpt from the article:
The correlation between the S&P 500′s 10 sectors currently averages 83.7%, compared to 85.7% in August and 89% in July, according to Nicholas Colas, chief market strategist at ConvergEx Group.
But before anyone gets overly excited, he notes these figures are still abnormally high. “We’d prefer to see the 50%-75% range of pre-crisis markets,” Colas adds. “It is, however, a step in the right direction.”
When these sectors are highly correlated, it means the stocks are struggling to differentiate themselves from their peers, and the market in general. In other words, it is more difficult for a stock to stand out – either negatively or positively – based on its own news or results.
We saw this in the earnings season of late July and early August. Stocks showed a tendency to rally with the markets even if they just reported 'middle of the road' or even lukewarm earnings. The idiosyncratic nature of the stock performance was muted during these months.
Why does my firm care about the correlation of the sectors? Mostly because we use sector rotation in our investment strategy. And we hedge our positions in those sectors. But if the sectors are not going to outperform each other by much, then it creates two challenges. First, sector rotation doesn’t add a lot of value if the sectors are not significantly outperforming each other. So, it is an added friction cost that is difficult to justify.

Second, when you look back and see high correlation between sectors and/or asset classes, you find that you could have just had a portfolio hedge in place instead of hedging every position. If you had used that approach, you typically would have saved money on your hedge.
But sectors and stocks becoming highly correlated is difficult to predict, so this problem is a lot more rear view mirror in nature. We don’t focus on the rear view mirror.  We focus on the forward vision we have.
Like the analyst in the story above, we are encouraged to see the correlation coming down for two straight months. But we’d like to see it come down even further. We are not willing to call it a trend yet, but we will track it.
If the correlation continues to decline, there are two ways we would be encouraged to play it: (1) increase our weighting in our sector rotation; (2) consider the occasional individual stock investment that we really like at that moment.
We aren’t big stock investors as we make our investments mostly in indexes and sectors. However, if the correlation continues to decline, it means there will be more outliers in stock performance. With the outliers comes the chance for outsized returns. When we have a good stock or sector idea, we’d be more likely to make that investment given the likelihood the market would re-pay you if we were correct!
No positions in stocks mentioned.

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