The Great Correlation Collapse

//The Great Correlation Collapse

The Great Correlation Collapse

As flat as the Kansas prairie. That’s one way to describe a volatility chart for the equity markets in 2017. Seemingly absent from Wall Street this year, volatility indexes are trading near record lows and rarely getting close to long-term averages. Our human nature likes a smooth ride, whether in a car or in our investments. For the former, we can thank good road and suspension engineers, but in the latter it is often less obvious. We should look around a bit more to find out where to direct our appreciation.

At the same time that volatility has bottomed, equity indexes have hit dozens of records through the year in a mostly linear way. According to LPL Financial, the S&P 500 recently set a record for how long it has gone without a decline of 3%. As of November 14, it has gone 50 sessions without a drop of 0.5%, a stretch last seen in 1968. And for the year it has experienced only eight sessions where the closing price changed at least 1%, an unusually small number of occurrences. Nothing to see here, please move on.

It seems our good fortune comes largely from the collapse in equity market correlations. Correlation refers to the degree to which two different securities, or groups of securities, move in tandem. A correlation of 1.00 means both assets move perfectly in tandem. A correlation of 0.00 means two assets move in completely opposite directions. According to DataTrek, Research, between 2012–2016, average sector correlations were 0.81; last month they were 0.37. According to data from S&P Dow Jones Indices, correlation for the S&P 500 was at 0.06% in October.

Today the landscape looks very different. Markets, asset classes and securities are moving independently of each other, and on a microscopic level, stock-by-stock and bond linkages are remarkably subdued. The effect of reprioritizing individual security attributes helps explain suppressed volatility. When one name goes up, another might go down, or another might go up even more based on the future earnings prospects of that name. Things are generally balancing themselves out without reverting to the severe ups and downs. As but one example, Dow component General Electric has fallen more than 43% this year, while the blue-chip Dow Jones Industrial Average is up more than 18%. This kind of divergence allows those who pick stocks, bonds or asset classes an opportunity to find rewards for their analytical work.

Can this go on? We think it can. In properly functioning financial markets, pricing signals reflect company fundamentals and their ability to earn decent equity returns, or service their corporate liabilities. These pricing signals should develop within the context of monetary and fiscal policy, not because of it.

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2018-02-22T09:37:04+00:00 November 22nd, 2017|Blog|0 Comments

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