Falling Sector Correlations – Positive News for Investors

93356036The correlations among S&P 500 sectors have dropped to the lowest level since the global financial meltdown. Though correlations may seem complicated, the development is actually excellent news for most investors.

An analysis of the last 60 trading sessions would reveal that the average correlation between the day-to-day moves of two S&P 500 sectors is around 0.47, and it was as low as 0.45 in the 60 sessions ending on June 9th, 2016.

That is significantly lower than the number’s median reading of 0.69 over the last five years and is a drastic drop from the 0.83 witnessed in October 2015. Both active and passive investors must be happy with this silent market trend.

For the active investors, who believe they can create value by overweighting certain sectors and underweighting other sectors, such results begin to make sense. For e.g., a portfolio that consists of several consumer discretionary stocks and some utilities stocks has a greater chance of performing differently in comparison to the S&P 500 in a low-correlation scenario.

The passive investors could also benefit. As correlations decrease, the advantage of variation increases since greater correlations convert into a lower degree of volatility without essentially decreasing the projected gain.

In a low-correlation environment, there’s a lesser risk that each stock one holds decreases together. Again, there’s also a lesser chance that each stock increases together, but since most investors do not like losses and like gains more, a reduced chance of the volatility that takes the portfolio higher is a useful trade-off.

According to chief market strategist Nicholas Colas, Convergex, “Five years ago the stock market went up together and everything went up together, or it went down together and everything went down together. And that was really unhealthy because it meant there was no value in diversification.”

At present, it is no longer the case. The alleged risk-on/risk-off dynamic seems to have fragmented, with a few discrete forces now affecting stocks. The main ones are the reach for yield amid dropping bond rates, the commodity comeback, and the current weakness in the U.S. dollar.

If investors select the correct force, they would be able to outperform the total market by a significant margin because of the correlation decline.

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