ConvergeEx Group’s Nicholas Colas has noted something “remarkable” this month when it comes to correlation:
...the rally in the S&P 500 of 3.8% over the past four weeks has come with HIGHER industry sector correlations. That’s unusual for U.S. equity markets, which have tended towards lower correlations in rising markets and clustered returns when things get ugly.
In fact, the average price correlation of the 10 major industry sectors (as tracked by their ETFs) to the S&P 500 tightened up to 89% last month, the highest level since late 2010. Since lower correlations are a necessary sign of healthy markets, this puts the end-of-second-quarter rally on the Greek debt “resolution” in serious doubt.
Yesterday’s decline of 1.8% for the S&P highlights the fragility of that recent move higher and supports this cautious interpretation of the correlation data. Gold, in contrast, continues to behave the way the textbooks say it should: little-to-no correlation with financial assets.
As to why these correlations are appearing in a rising market, Colas believes there’s almost something Pavlovian about it. He cites the example of the behavioural patterns of his dog. The dog in question, he says, has equated July 4 fireworks and nighttime thunderstorms with loud sounds, thus making a connection in its head between the darkness and scary noises. Said dog is thus no longer keen to go outside at evening time for walkies.
Colas says this is evidence of the dog’s clear inability to differentiate between causation and correlation.
Yet, says Colas, investors seem to be making the same mistake.
As he notes:
Take the rally of the last month or so. The S&P 500 is up 3.8% over the last four weeks, even with the back-to-back selloffs of Friday/Monday. That puts the year-to-date return at 4.9% and, all things considered, these are not bad returns for a stock market beset by worries about Federal Debt Limits, Eurozone solvency, Chinese inflation and still-high domestic unemployment. Carrying the canine storyline one step further, the fundamental pitch for owning equities could be considered downright Pavlovian. Hear the bell (stocks are going up), so food is on the way (the economy will recover and yield an even more robust market for stocks). Drool accordingly. Equities.
So what’s wrong with last month’s equity move?
In Colas’ mind it’s the very fact that all the equities went up together. This simply shouldn’t happen in a rising market and possibly suggests the rally has not been created equal.
Indeed, as his findings note:
The average correlation for the various industry sectors of the S&P 500 rose to levels we haven’t seen since the end of 2010. All rallies are not created equal. Those based on economic reality tend to favor some industries and ignore others. An early-cycle rally might see banks stocks move higher and push down “safe haven” equities such as pharma or consumer staples names. Mid-to-late cycle stock market advances might see money flow to commodity names at the expense of financial services concerns such as insurance companies. At an average 89% correlation to the price action of the S&P 500, the 10 industries of that index traded in virtual lock-step with the index as whole.
That makes me suspicious of the end of month/end of quarter rally we saw late in late June. Yes, we had the catalyst of the Greek vote for austerity to provide a much needed fillip to stocks. But how can you take seriously a rally that doesn’t differentiate between Industrials, Technology and Consumer Discretionary stocks? Those three sectors all showed correlations to the S&P 500 of +94% over the last four weeks. Just two months ago the price correlations for those three sectors were an average of 88%. And back in February 2011, the correlations for all 10 sectors of the S&P 500 was 74%. Simply put, sector correlations moved dramatically higher in June.
A view that definitely makes sense if you consider under what sort of scenario such varying sectors as industrials, technology and consumer discretionary might really all perform in tandem. (Presumably the opposite of a selloff, i.e. panic buying – no?)
Related links:
BarCap on correlation and ETFs – FT Alphaville
Lost in correlation fatigue – FT Alphaville