Via ConvergEx's Nicholas Colas,
Just when you thought the 8 year bull market for US stocks had shown us everything, something new comes along.
One sector just posted a negative daily price correlation to the S&P 500 over the last month, the first time any industry group has managed that since we started tracking the data in October 2009. The lucky sector: Utilities, with a -25% price correlation AND a positive 2.5% return over the month. That’s not as good as the S&P 500 (+3.0%), but still a reasonable gain for a negatively correlated asset. Overall, sector correlations remain low with an average of 57.1% to the S&P 500 and only 3 sectors over 80% (Industrials, Technology, and Financials). And as geeky as this all sounds, it is important if you want to understand why the CBOE VIX Index is so low. Lower correlations dampen price volatility for the S&P 500, with a feedback loop into expected volatility (which the VIX measures).
Bottom line: want to see the VIX ramp higher? Better hope correlations start to increase soon.
Bedazzled. Swagger. Addiction. No, those are not descriptors of an insufferable teen pop icon in rehab. They are all words invented by William Shakespeare, who seemed to have a middle schooler’s creativity for creating new words when he wasn’t happy with the ones already in circulation. Other examples: eyeball, manager and assassination. For more details (and other Shakespeare-invented vocabulary) see here.
Perhaps the Bard’s greatest etymological innovation was, however, “Weird” – even if it was accidental. In its Old English form (wyrd) it meant “Fate, chance or fortune”. In Macbeth, the three witches were “Weird sisters” – the three Fates that control human destiny from Greek and later mythology. Since they had to look suitably scary or odd on stage to create the desired effect on the audience, “Weird” became synonymous with “Uncanny” or “supernatural”. See here for more details.
“Weird” still has the power to draw us in, even from just morbid fascination; how many times have you clicked on an internet ad or email with the subject line “This one weird trick will make you… (fill in the blank)”? Maybe it even got you to open this email. Doesn’t matter now…
I won’t leave you hanging, however, because in our monthly review of asset price correlations for stocks, commodities, fixed income and currencies we did find “One weird thing”. Typically, every equity sector (Tech, Health Care, Financials, etc.) shows some positive correlation to the S&P 500. During the Financial Crisis and for many years after these correlations were very high – over 90% on average in some months. Their typical pre-Crisis levels were closer to 50%, indicating that about half of a given sector’s performance was driven by the broader equity market and the other half from industry-specific fundamentals.
Over the past 30 days, US large cap Utilities have been negatively correlated to the price action in the S&P 500 to the tune of (25.3%). It is the first negative reading we’ve seen since we started tracking this data on a monthly basis back in October 2009. As you can see in the accompanying tables and charts, the Utility sector did get pretty close to zero correlation twice: June 2014 (5.3% correlation to the S&P 500) and August 2016 (2.4%). But this is the first reading below the zero line.
At first blush the reason for this anomaly seems easy: investors must be dumping Utilities since they expect long term interest rates to rise and this group is the most bond-like of any sector in the S&P due to its high dividend payouts. But no – bad answer. The Utility sector is up 2.5% over the last month. That’s not equal to the S&P’s 3.0% return, but it isn’t a loss. It’s just that when Utilities “zigged”, the market “zagged”.
The point here isn’t just a fun bit of market trivia – the price action in Utilities highlights that most S&P sectors are actually trading with more independence from the equity market as a whole ever since the election last November. Average sector correlations have plummeted from 75-80% pre-Trump win to 57-62% afterward. Last month the average was 57% (and would have been 65% without the negative reading from the Utility sector’s negative correlation).
Only three sectors currently now have price correlations to the S&P 500 index in excess of 80% (what used to be the “Old Normal”): Industrials (89%), Technology (85%) and Financials (90%). Tech is a large part of the S&P 500 (21.5% as of the end of last month), so it can only stray so far from the index itself. Financials are now in second place (14.8% weighting) and are a key part of the “Trump trade”, as are Industrials (10.2% of the index).
This drop in correlations is just as much a part of the “Trump rally” as the appreciation in asset prices from the lows on election night. In some ways, they are even more important since we have seen a strong rally for 8 years so there’s nothing really new about higher US stock prices. This decline in common price action is, however, truly unique to the post November 2016 period of market history.
The other important factor to remember when it comes to lower correlations is their effect on price volatility for the S&P 500 as a whole. We saw a good note on the Bloomberg website today that summed it up well: “A Freakish Calm Surrounds the Eight-Year Bull Market”. It’s not the “One weird thing” but it gets the right points across.
When correlations drop, volatility declines right along with it. That’s just the math of risk and return in a portfolio. Include an asset like Utility stocks to a portfolio last month and on days when the market is down that group might well be up. Granted, Utilities are just 3.2% of the S&P 500, but every little bit helps. Also, consider that heavier-weights like Heath Care (just 47.5% correlated to the S&P this month) and Consumer Staples (44.5% correlation this month) have a 14.1% and 9.4% weighting in the index.
The conclusion here is that US equity markets aren’t in low-volatility mode simply because someone turned on the “Trump trade” autopilot and settled down for a nap. OK, there is some of that. But in addition to waiting on tax cuts, deregulation and infrastructure spending, capital markets are more aggressively looking for winners and losers from those key fundamental drivers. In the process, stock prices are less coupled to general index direction than they have been in years. And that makes volatility lower than we’re used to seeing.
It’s not weird; it’s just math.