For Stockpickers, It's Now Or Never
If you are a stock picker, then it’s basically now or never for whatever investment discipline you might follow. Asset class and industry correlations have taken a surprising nosedive in recent weeks, which - as ConvergEx's Nick Colas notes. should allow your strategy/blend of magic to (hopefully) shine versus the benchmarks. Average industry sector correlations to the S&P 500 have dropped to 69.9%, by far the lowest observation for over two years. High yield bonds now show just 16% correlation to U.S. stocks, and the numbers for Emerging Markets (58%), EAFE stocks (76%), and currencies like the Australian dollar (11%) are also plumbing new lows. Why the sudden return to a ‘Normal’ world? Expectations that the Federal Reserve will begin to ‘Taper’ its bond buying help, to be sure. As do actual inflows (some $8 billion last month) into actively managed mutual funds. We’ll have to wait and see if current trends continue, but for now we welcome the return of the ‘Stock picker’s market’. Let the dart-throwing begin...
Via ConvergEx's Nick Colas,
What do the NYC Subway system, CBS Sports and the television show ‘The Office’ have in common? They all use Helvetica as their “Typeface” – the unique combination of design features that the type characters in a given text share. Moreover, they aren’t alone in their choice of this font type, with Crate & Barrel, American Airlines, American Apparel, Jeep, Toyota, Scotch tape, Evian, North Face, Blaupunkt and many other corporations using it for their logos. Helvetica is actually a relative newcomer to the world of typefaces, developed in the late 1950s in Switzerland (‘Helvetii’ was the Roman name for the tribes who lived in the region 2,000 years ago). The process of designing typefaces goes back to the first printing presses, and over the centuries companies developed and sold thousands of unique physical type blocks to printers.
What makes Helvetica so popular among graphic designers today is its lack of ornamentation and easy readability. To illustrate that point, consider the following:
Picture a U.S. Internal Revenue Service tax form, or those parental guidance ratings that pop up before television shows. Both use Helvetica.
Now imagine if you saw the same letters in some playful font, maybe with smiley faces dotting the I’s. You’d think that was frivolous and probably untrustworthy.
And what if the text appeared in some heavy old English font, like the one used by The New York Times for its banner? That would be hard to read to quickly, and might appear old-fashioned to boot.
Helvetica, by contrast, has no ulterior motive; the medium is not the message. Critics of Helvetica’s near-universal acceptance posit that its ubiquity reduces its effectiveness, but so far the opposite seems truer. We see so much of it that other typefaces can seem artificial and harder to read.
Since the Financial Crisis some 5+ years ago, capital markets around the world have largely been in their own Helvetica-style world of sameness. The code words were “Risk on” and “risk off” and essentially any risk asset (stocks, corporate bonds, non-dollar currencies, even commodities) traded in lockstep. Optimism took them higher, pessimism moved them lower. Some assets – read U.S. stocks – did better than most other investment types, but on a month-in month-out basis most classes of investments were either red or green together.
This is not the way global stock and bond markets are supposed to work. The bedrock of all academic research into the behavior of capital markets rests on the value and power of diversification. Own two assets that don’t move in lock-step and you have a portfolio with a better risk-reward tradeoff than if you own just one. Invest internationally, for example, because different economies move at their own distinct tempos. The same holds true for commodities, bonds, and currencies. If all these move similarly, as they have for over half a decade, then there is simply less reason to put money to work.
Surprisingly, the last month of correlation data for a whole variety of asset classes and industry groups shows that perhaps the long wait for more normal capital markets is finally over. We’ve been tracking this data since the Financial Crisis, waiting for this moment. There are several charts and tables with the data after this note, but here is the highlight reel:
The 10 industry sectors of the S&P 500 currently show the lowest average correlation to the broad market of the last several years. Last month this number was 70% - the month before was 89%. More surprising is that the selloff of the past week didn’t shift this number higher, as it has done in every market decline since 2008. As for specifics sectors, tech stock correlations to the S&P 500 are down to 58% from 92% last month and Utilities sit at a 47% correlation down from 75% the prior month.
High yield corporate bonds now show a 16% correlation to U.S. stocks, down from 66-67% in each of the last 3 months. Investment grade bonds now move essentially independently of stocks, versus a 49% correlation last month.
International equities – emerging or developed markets – now sit at 58% and 76% respectively. Prior months were all over 80%.
Precious metals maintained their historical low-correlation relationship to stocks at 5% for silver and 15% for gold.
The movement of the Australian dollar broke free from its historically high correlation relationship with U.S. equities. Three months ago the price correlation between the two was 73%; now it is 11%.
These moves are about as shocking as walking into your teenage child’s room to find it neat and tidy, with your progeny sitting at their desk reading next week’s homework assignments. You are happy to see it, but perhaps a little suspicious. And so it is here. Why have capital markets so quickly returned to their pre-Crisis levels of correlations? Old timers in capital markets will tell you that 50% correlations between industries and the broad market were once the norm. We’re getting back there after years of 90% readings. Three thoughts here:
Perhaps capital markets are actually preparing for the U.S. Federal Reserve’s reduction in bond buying and starting to pick winners and losers on fundamentals. This would be welcome news to everyone from stock picking analysts and portfolio managers to individual investors. Lower correlations means more capital can flow into asset markets around the world and maintain the same levels of risk. That is also profoundly good news for brokers, asset managers and other businesses which need incremental volumes to generate earnings growth.
Active money managers – mutual funds, for example – have started to see inflows into their products. According to the Investment Company Institute trade group data, U.S. equity mutual funds saw $8.8 billion of fresh investment in July, only the fifth month of inflows since January 2011. New money into active management means PMs finally get to write ‘Buy’ orders for their favorite stocks and sectors, rather than passive investment vehicles just buying the relevant index. Marginal dollars set prices – and correlations.
It could all just be a fluke. We’ve had plenty of head fakes of various types in the last five years which seemed to portend a return to more normal macroeconomic and market routines. While the data is very welcome, it would be wise to take it with a grain of salt until we see these trends hold.
As a closing thought on this topic – and how it relates to Helvetica and type design – consider this quote from Steve Jobs: “Design is not just what it looks like and feels like. Design is how it works.” Jobs was a huge fan of calligraphy and type design, incorporating that passion into hardware, software and media applications at Apple and elsewhere. I think his sentiment also holds true for capital markets. While seeing U.S. stock markets make news highs recently might be heartening, that’s just “Look” and “feel”. Lower correlations are “How it works”, and for the moment things are certainly working better.