Back on January 14 (so, back when everyone was still under the impression that nothing could possibly go wrong for equities), I asked if stock picking was dead.
The first bullet point in the summary for that linked post reads as follows:
You'd be forgiven for asking whether stock picking is worth the effort in an environment where benchmarks only go up.
I also highlighted the following rather amusing screengrab from a Bloomberg article dated January 12 that kind of underscores how investors were feeling during the first three weeks of 2018 as an avalanche of inflows into U.S. equity funds predicated (at least in part) on the assumption that the Trump tax cuts portended more gains ahead, pushed the S&P through multiple analysts' year-end 2018 targets:
img src="https://static.seekingalpha.com/uploads/2018/1/13/47439673-1515873329278574.png" width="640" height="148" data-width="640" data-height="148" data-og-image-twitter_small_card="false" data-og-image-twitter_large_card="false" data-og-image-twitter_image_post="false" data-og-image-msn="false" data-og-image-facebook="false" data-og-image-google_news="false" data-og-image-google_plus="false" data-og-image-linkdin="false"">>Recall the following chart I posted on January 17 amid the euphoria:
img src="https://static.seekingalpha.com/uploads/2018/4/16/47439673-15239013321105592.png" width="640" height="294" data-width="640" data-height="294" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>(Heisenberg)
Those were the days, were they not?
Needless to say, things got dicey shortly after that and some of those year-end targets that were quickly eclipsed in January aren't looking so silly anymore. In fact, with each passing escalation in the burgeoning global trade war (and now we're apparently going to have to think about a currency war as well), some of the S&P targets that were looking pessimistic in late January now seem optimistic.
One thing I noted in the post linked here at the outset is that at the time, stock correlations had plunged. Presumably, that had something to do with falling macro uncertainty. That is, the more sure-footed investors became about the macro environment, the more they began to focus on micro (e.g., company- and sector-specific) factors. Here's what Goldman wrote about that:
We find that stock-picking opportunities are highest when equities are in the Growth phase of the equity cycle and when the economic cycle extends. This is because in this phase returns are driven by actual earnings growth rather than by expectations of a recovery or a deterioration in the cycle. In these parts of the business and equity cycle, pairwise correlations tend to be the lowest and the source of dispersion more micro-driven. When the economic backdrop improves and sentiment is ‘risk on’, company fundamentals tend to be at play, as the influence from macro drivers of sector performance (e.g., bond yields) fades.
Oh what a difference three months makes. Fast forward from the time those lines were written to late last week and S&P 500 correlations had risen to 52% from just 9%. As Goldman writes in a new note, that's "the largest and fastest change on record outside of 1987." Here's the rather dramatic visual on that:
img src="https://static.seekingalpha.com/uploads/2018/4/16/47439673-15239021938462107.png" width="640" height="386" data-width="640" data-height="386" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>(Goldman)
I don't think I need to tell you this, but some of that is probably due to the fact that investors are increasingly turning to ETFs like SPDR S&P 500 Trust ETF (SPY) and PowerShares QQQ Trust ETF (QQQ) when it comes to jumping in and out of the market. I talked about this on Sunday, when I cited a separate Goldman note on the way to suggesting that passive vehicles are driving up volatility. In the note the chart shown above is from, Goldman writes the following:
Average stock correlations declined to an all-time low of 9% driven in part by the creation of winners and losers from tax reform. However, stocks have become more correlated during the risk-off events since January. Investors increasingly migrated to ETFs and other index products, offering little stock-level differentiation of the potential impacts from trade and regulation.
On Friday, Bloomberg was out with a short piece that touches on this as well. Here's a short excerpt and a chart:
ETF flows have been swinging by $40-$50 billion a week as investors react to volatility and selloffs for the first time in years. ETF flow volatility has tripled this year.
img src="https://static.seekingalpha.com/uploads/2018/4/16/47439673-15239110411709213.png" width="640" height="349" data-width="640" data-height="349" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="true" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>
Here's the visual that shows you average three-month stock correlation (as noted in the annotation, Exhibit 1 above is the spike off the 3-month low):
If you go back and read the "is stock picking dead?" piece linked above, one of the other points I made was that low correlations could spell opportunities for stock pickers assuming volatility is high enough for performance spreads to widen out. Of course, the issue there is that when correlation is low, volatility tends to be low (things aren't moving in the same direction at once). Well, volatility has certainly picked up of late, but as Goldman writes, the spike in correlation was more than enough to negate the effect on dispersion:
Return dispersion, defined as the cross-sectional standard deviation of individual stock returns, represents the size of the opportunity set for stock-picking. 3-month S&P 500 return dispersion stands at just 20 pp, well below the 30-year median of 26 pp and the 10-year median of 24 pp. Return dispersion is lifted by high volatility or low correlation, all else equal. Although equity volatility has picked up YTD, stock correlations have risen substantially as well, constraining return dispersion.
Ultimately then, stock pickers have been out of luck during the selloff, very much contrary to what you'll hear from those telling you that they're "buying more" on each dip. They may indeed by averaging down in terms cost basis, but finding differentiated opportunities amid the intermittent malaise has been exceedingly difficult.
It's possible that earnings season could change this dynamic, but what I would caution is that in certain sectors, circumstances seem to be conspiring to keep correlations elevated. For instance, in tech, regulatory concerns and the threat of more tariffs related to IP "theft" by China could make it difficult for investors to find safe havens in the space in the event of another tech-driven drawdown for the broader market.
Goldman touches on that risk and also mentions financials. The yield curve continues to collapse, and decent earnings notwithstanding, one wonders how long the sector will be able to ignore this:
img src="https://static.seekingalpha.com/uploads/2018/4/16/47439673-15239108058339398.png" width="640" height="280" data-width="640" data-height="280" data-og-image-twitter_small_card="true" data-og-image-twitter_large_card="true" data-og-image-twitter_image_post="true" data-og-image-msn="true" data-og-image-facebook="false" data-og-image-google_news="true" data-og-image-google_plus="true" data-og-image-linkdin="true"">>(Heisenberg)
So you know, good luck out there with the stock picking. Ironically, what you would need in order to see more opportunities on that front is for volatility to pick up enough relative to the spike in correlations to drive up dispersion.
See there? You're hoping for more turmoil and you didn't even know it.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
This news has been published by title This Hasn\'t Happened Since 1987: S&P Correlation Edition
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