Falling Correlations Put Stock-Specific Attributes in Driver’s Seat

By Clay Cleek of Thornburg Investment Management

Low market correlations make it easier for active portfolio managers to stand out—positively or negatively. But what matters most is how a portfolio of select stocks performs through market cycles, regardless of correlations.

As third-quarter earnings season gets underway in earnest this week, equity market participants are expecting company fundamentals and reported results to be larger drivers of performance for large U.S. firms than at any time since the year 2000. Last week, implied correlations for the 50-largest U.S. stocks (measured from options prices for individual stocks and the S&P 500 Index) fell to a record low, which can be interpreted as investors pricing in almost zero macro risk.

In August, realized correlations for the largest 50 stocks matched the year 2000’s all-time low of 0.03. This continues the upward trend of falling implied and realized correlations, and is a welcome change for active portfolio managers. It also marks a move away from the high correlations and low dispersion that have led some to describe the current market cycle as “the most unloved bull market in history.” Why? Perhaps central bank monetary policy swings, and the associated asset price distortions and periodic market panics over heavy debt loads, have something to do with whipsawing markets: risk-on/risk-off periods have pushed implied correlations as high as 0.98 since the financial crisis, according to an interesting October 9 article in the Wall Street Journal, which cited Credit Suisse data.

Fundamentals-focused investors expect to add value by finding stocks that are trading below their assessed, long-term intrinsic value. Low equity market correlations can be favorable for truly active managers—whose portfolios tend to look very different from their index benchmarks—when the market isn’t moving in lockstep. That’s when fundamental aspects of an individual company’s performance in terms of top- and bottom-line growth, margin expansion, market share growth, balance sheet health, etc., become more recognized by the market, rather than subsumed by a broader macro theme.

An inverse way of looking at it is through an equal-weighted measure of factor-specific risk for various indices, calculated by regressing historical returns against a host of risk factors. What cannot be explained by these factors is deemed stock-specific or “idiosyncratic” risk, which we have seen rise significantly for major indices in the past year. It represents the easing of a market correlation headwind to stock-by-stock, fundamentals-based investing.

Average Stock-Specific Risk 7/31/2016 - 9/30/2017

Source: FactSet

Over the long run, stocks with strong business models and attractive returns on invested capital usually do well, whether market correlations are running high or low at any particular time. While it’s easier for stock pickers to stand out—positively or negatively—when correlations are low, what really matters is how a portfolio of select stocks performs over full market cycles. Longer timespans better reflect a portfolio’s risk-adjusted returns, whatever the market correlations at any given time.

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