Are Elevated Correlation the New Normal? By Sam Stovall S&P Equity Research
Sectors within the S&P 500 have exhibited a similar trend.
- The correlations of many assets with domestic stocks have increased during the past 30 years.
- The availability of mutual funds and Exchange Traded Funds has contributed to this trend.
- Correlations of the S&P 500 with all 10 of its component sectors are at or near their highest points in 20 years.
Over the past 30 years, the variability of asset class correlations with the S&P 500 made building a diversified portfolio a lot easier than it is today. Since 1978, the average rolling 36-month total return correlation for small-cap stocks with the S&P 500 of 0.82 has been high for small U.S. stocks, but not ineffectual. (A correlation of 1.00 indicates that both the direction and magnitude of monthly moves are identical, while -1.00 is like your sibling who does the exact opposite of what you say and do. A 36-month correlation was the shortest time frame suggested by our in-house statistical experts.)
During these past 30+ years, true diversification was available through bonds and commodities, as the correlations for the Barclays Aggregate Bond Index versus the S&P 500 averaged 0.26, while the S&P Goldman Sachs Commodity Index registered only 0.04. Along the way, some correlations have become even more appealing, as the lowest rolling correlation went negative for emerging market equities, REITs, commodities and bonds, and dipped below 0.20 for developed international equities. Unfortunately, for much of this period of more than 30 years, the availability of investible securities that replicated these asset classes was either limited or nonexistent, thus undermining one’s ability to achieve the diversification benefits of the benchmarks. Since the introduction of mutual funds and Exchange Traded Funds (ETFs) that mimic these asset classes, however, the correlations have risen, and for some, quite dramatically.
Rolling 36-Month Total Return Correlations
With the S&P 500, 12/31/1978 to 11/30/2010
Sources: Standard & Poor’s; Center for Research in Security Prices; MSCI-Barra; NAREIT; Barclays Capital; Goldman Sachs. Past performance is no guarantee of future results.
Today, the correlations with the S&P 500 for U.S. small-cap stocks, international developed and emerging market equities, as well as REITs and commodities, are at all-time highs on a price-only basis, or near the highs on a total-return basis. What’s more, the total-return correlations with the S&P 500 have risen significantly in just the past 10 years. Indeed, the greatest jumps in correlations over the past decade have been seen in the bond aggregate, commodity and REIT indices, so that four of the six asset classes analyzed have correlations in excess of 0.80. Possible reasons for the increase in asset-class correlations are awareness and availability, particularly since the advent of ETFs.
Many investors may be focusing almost exclusively on technical analysis, trading a handful of equities or sector ETFs in an attempt to successfully alternate between short-term positions in either cyclical or defensive sectors. As a result, price-only correlations for the S&P 500 Consumer Discretionary, Consumer Staples, Energy, Industrials, Information Technology, Materials and Utilities sectors are at or near all-time highs, and correlations for all 10 sectors in the S&P 500 are well above their 20+ year averages.
S&P 500 Sector Correlations With the S&P 500
Rolling 36-Month Correlations With the S&P 500, 12/31/1989 to 11/30/2010
|S&P 500 Sector||Low Value||Date||Average||High Value||Date||Current|
Source: Standard & Poor’s Equity Research. Past performance is no guarantee of future results.
Since 1989, which is as far back as S&P 500 sector data extends, the average rolling 36-month price correlations with the S&P 500 for cyclical sectors — Consumer Discretionary, Financials, Industrials, Information Technology and Materials — have ranged from a low of 0.74 for Materials to a high of 0.87 for Industrials. What’s more, the traditionally defensive sectors — Consumer Staples, Health Care and Utilities, and to a lesser extent, Energy and Telecommunications Services — have seen their correlations average from a low of 0.42 for Utilities to a high of 0.66 for Telecom Services.
Indeed, during the past 20 years, Consumer Staples and Utilities have seen their correlations with the “500” dip below zero, while others have seen them fall from about 20% below their long-term average for Consumer Discretionary and Industrials to more than a 75% decline from the average for Health Care. Talk about diversification opportunities!
Today, however, Consumer Staples, Industrials and Information Technology are sporting correlations that are at all-time highs, while Consumer Discretionary, Energy, Materials and Utilities are only one point or less away. In addition, seven sectors set all-time highs during 2010. Even though Financials, Health Care and Telecom Services have some space between their current levels and their prior highs, all 10 sectors have correlations that are currently above their long-term averages.
Are Elevated Correlations the New Normal?
We think investor conditioning, combined with a range-bound market, has caused investors to embrace an on-again, off-again approach as if they were pulling petals from a daisy. As a result, they have increased asset class and sector correlations toward all-time highs. Is this the new normal? While we believe correlations will likely remain above long-term averages, due to conditioning and increased asset-class availability, we don’t think they will stay at these extremes. EPS forecasts and demand projections are not identical for all asset classes. As a result, we still think diversification has its merits. However, today’s high correlations will also likely remain as long as economic projections and fundamental forecasts remain at odds and until some catalyst forces a change.
Also, we don’t think that Modern Portfolio Theory (MPT), which attempts to maximize returns while minimizing risks, failed us in 2008, since the S&P 500 registered a total-return of -37%, while long-term Treasury bonds gained nearly 23%. Just as was the case during the bear markets of the mid-1970s and early 1980s, when the health of the global economy was in question, the equity-oriented and economically sensitive asset classes fell in unison in 2008, as investors braced for a global recession. Going forward, while subsequent bear markets in the S&P 500 will likely drag down other equity-oriented asset classes, commodities and REITs may once again offer some shelter from the storm as they did in prior garden-variety bear markets.
Source: Standard & Poor’s Equity Research
By Sam Stovall, Chief Investment Strategist