Wednesday, August 28, 2013

Uncorrelated Correlations: Market Correlation Changes Create Opportunities

Falling Correlations in the Stock Market

In 2008-09, the sell-off in stocks was deep.  Nearly every company in every industry was hit hard – regardless of credit quality or fundamentals.  Coming out of 2009, stocks continued to trade very much in lockstep with one another.  Companies with very different fundamental values were trading up or down by very similar amounts.  In other words – the market was not rewarding strong companies more than weaker ones. 

Over the past 5 years, that trend has steadily been reversing.  The CBOE Implied Correlation Index measures the average correlation of stocks that comprise the S&P 500 against the S&P 500 Index itself.  The Implied Correlation Index has been on a year-over-year decline since 2008-09.  The trend has continued this year, as correlations have trended downward from year-end 2012 highs above 70 to current levels in the low 50’s (see chart below).

S&P 500 Implied Correlation Index Historical Data (
Stocks are no longer moving together quite as tightly as they have over the last 5 years.
  Companies are being rewarded based on different characteristics.  Over the past few months, we have seen a very distinct shift in investor preferences.

To start the year, investors flocked to slow-growth, high-dividend yielding stocks (those we define as “C” stocks – see recent Seeking Alpha post), while companies with more attractive growth prospects (“A” stocks and some “B” stocks) were not being rewarded.  The Dow Jones Industrial Average – which is comprised of more higher dividend-yielding, lower growth stocks – outperformed the S&P 500 – which is comprised of lower dividend-yielding, higher growth stocks – by approximately 2% from the beginning of the year until the end of April.

We suspected that trend would change, as it has.  From May until August 23, the S&P has beaten the Dow by approximately 2.5%.  In the past week, roughly 70% of the 30 stocks in the Dow under-performed the S&P 500.  Money was moving disproportionately into the high-yielding, slow-growing stocks to start the year, and it has now begun to move disproportionately out of them.  Over the coming months, we expect the shift to more low-yielding, higher growth dividend stocks to continue.  Growth stocks will begin to be rewarded, especially if expectations for better earnings and dividend growth in the 3rd and 4th quarter of 2013 continue to hold. 

Rising Correlations in Fixed Income Markets

The exact opposite correlation trend has appeared in the fixed income market.  Investors have been selling fixed income assets of all quality levels in front of the Fed’s expected mid-September taper of Quantitative Easing (QE).  The difference between the fundamental values of fixed income assets is not being rewarded – just like the differences between fundamental company values was not rewarded coming out of 2009.  As we mentioned in last week’s Take Aways, we believe the market’s reaction to Fed tapering has been overblown.  The current disconnect between fundamental value and price has created buying opportunities, particularly in municipal bonds and preferred stocks.

We continue to hold our opinion that rates will stabilize in the near-term.  The market is pricing fixed income assets as if the Fed will taper $15-20 billion at its September meeting.  The recent mixed economic data may lead the Fed to extending QE a bit further.  Other scenarios are:
  1. Taper the purchase of U.S. Treasuries, but less than expected ($5-$10 billion reduction).
  2. Modestly diminish purchase of Treasuries, while maintaining the full monthly purchase of mortgage bonds.
  3. Keep Quantitative Easing at its current $85 billion per month purchasing pace. 
In our opinion, 3 out of 4 of those potential scenarios would likely lower interest rates.  Even if the Fed were to reduce its Treasury purchases by $20 billion a month, it would still be buying nearly 50% of the expected net Treasury issuances for the 3rd Quarter and even more as the Federal deficit shrinks closer to $700 billion.

Regardless of the Fed’s next actions regarding QE, they have made it very clear that they will maintain stimulative monetary policy for the foreseeable future.  Bernanke has stated that the Federal funds rate will remain near 0% until 2015, which will continue to put downward pressure on interest rates – even after QE is completely phased out.  The Fed is going to continue to support the economy for a very long time and we don’t intend to fight them.