You might think that the stocks of various companies would move independently of each other depending on the idiosyncratic fundamental merits of those particular companies.
While this might be true in the long-run, it’s rarely true in the short-run, especially during times of financial panic and crisis.
During bouts of panic and fear in the markets, asset correlations, or the degree to which the prices of two assets move in the same direction, spike. When correlations go up as prices are tanking, it means people are just dumping everything with little regard to the asset-specific fundamentals. It’s something that’s been observed repeatedly during past financial crises. It’s something that’s being observed now.
This is a brutal environment for stock-picking investment pros whose successes are measured by their abilities to distinguish between the winners and the losers in the market.
“During the last month, stock correlations skyrocketed as indiscriminate macro pressures pummelled the S&P 500 index and weighed on the stock-picking environment,” Goldman Sachs’ David Kostin writes. “Leaving few stocks unscathed, recent equity turbulence drove S&P 500 stock correlations from 30% to 56%, the highest levels since the 2011 European crisis.”
Conversely, when correlations jump, the variation in returns falls. This is measured by the dispersion of returns.
“As correlations spiked, return dispersion — measured as the cross-sectional standard deviation of stock returns — fell, leaving bottom-up stock pickers with a diminished opportunity set for generating alpha,” Kostin continued.
This isn’t just an S&P 500 phenomenon. It’s a global stock market phenomenon.
“Regional equity correlations have risen sharply after troughing late last year,” Morgan Stanley’s Andrew Sheets writes. “Japan stocks, historically a big source of diversification, have recoupled sharply with global equities.”
And it’s not just a stock market phenomenon. It’s happening in other asset classes to.
“Regional correlations within asset classes hit new highs amid the August turmoil, yet cross- asset correlations are not as extreme,” Sheets observed.
So, what are investment pros to do? Well, according to Ritholtz Wealth Management’s Josh Brown, they’re BS-ing to their clients. From Brown’s blog: “Josh here — the other day I heard a PM from a stock-picking asset management firm on a phone call with an investor. He very methodically went through the fundamental outlook for 20 different stocks he was invested in. I felt bad that the person on the other end of phone wasn’t told how little this stuff matters to current prices, when correlations are spiking and emotions dictate multiples. Rather than grabbing the phone away, I listened with rapt attention as 15 minutes of nonsense was communicated. The elephant in the room — sentiment — went unaddressed.”