“Correlation” isn’t usually a dirty word on Wall Street. The term refers to how closely two asset classes or securities move in relation to each other. As long as traders know what the relationships are, and are quick to catch on when those relationships change, they don’t tend to gripe too much about the specific ties that do or don’t exist.
Ask an investment manager what he or she thought of the correlations among stocks in the S&P 500-stock index in 2011, however, and you’re liable to meet with dark looks and unprintable comments.
Active stock-pickers – among whose ranks we can place the majority of mutual fund managers as well as many investment advisors and brokers who construct portfolios for their clients – count on the components of the S&P 500 to vary in their price movements and returns. After all, if every stock behaves pretty much the same as the overall index, there’s no point in taking the extra risk associated with buying individual names rather than the entire index, or with placing bigger bets on some stocks while ignoring others.
But in an investing environment like the one we saw in 2011, individual strengths and weaknesses of specific companies matter less to the stock price of each than the overall direction of the market, within a certain range.
The phenomenon first grabbed investor attention in 2010, as trading levels in exchange-traded funds and other broad index-based products soared. Bill Stone, chief investment strategist at PNC Asset Management Group, was one of those who noted it with alarm but who predicted the level of correlation would fall in early 2011. So it did, to levels that were the lowest seen in four years – but only briefly.
Macro issues – notably the sovereign debt issues in Europe and the ugly partisan debate over how to manage U.S. government debt levels and public finance – emerged as the single largest determinant of financial market trends in the second half of the year.
Indeed, in his year-end report, Stone detailed how, on any given day over a rolling 63-day period in the fourth quarter, about 85 percent of the stocks in the S&P 500 moved in the same direction as the index itself. No wonder that one of the best-performing stock mutual funds in 2011 was the Pimco StocksPlus Long Duration fund (PSLDX), which doesn’t actively manage the equity portion of its portfolio but only invests in stock derivatives, such as index futures. (It does actively manage its collateral for those derivative holdings, in fixed income securities.)
A correlation of 1 means the two items move together in perfect sync, while a correlation of -1 means they move in opposite directions. There’s no magic threshold at which point active investing goes from being potentially rewarding to less rational behavior, but a correlation level somewhere between 0.45 and 0.55 – the averages since 1972 and 2000, respectively – are a logical starting point, while anything north of 0.7 tends to ring alarm bells.
With correlation levels within the S&P 500 ending the year at the highest levels on record, as Stone points out, it’s going to be tricky for active stock pickers to outperform. Your large-cap investment manager can have an IQ of 190 – and it just won’t matter in an environment when markets are volatile and investors tend to buy or dump stocks en masse in response to macro signals rather than buying or selling based on long-term company-specific trends.
As long as this high level of correlation remains in place, the only active managers likely to outperform are those with strategies that are eclectic, crossing the traditional boundaries created by indexes, or those who concentrate on parts of the market where correlations remain lower. It’s another example of an apparently esoteric market metric that really, really matters.