Wall Street pros pine for a “stock-picker’s market” the way Washington pundits extol “bipartisan cooperation” and sportswriters plead for jocks to show hustle and humility.
All of these are idealized conditions, according to conventional wisdom – the way the system was supposedly meant to work, adhering to reason and rewarding effort.
Well, we now have such a stock-picker’s market – more so than any time since before the financial crisis – with tickers moving according to individual company substance and the stories analysts tell about them. Performance-stalking investors are understandably welcoming this shift.
But they might also bear in mind that, when the tape begins to winnow winning stocks from losers to an extreme, it is one clue of a complacent market that can be insufficiently alert to large macroeconomic risks, which have diminished but not disappeared.
Going Their Own Way
Both to the naked eye and according to statistical measures, individual stocks are increasingly going their own way rather than moving in unison.
A scan of the new 52-week highs and lows shows social-media-tinged stocks such as Facebook Inc. (FB), LinkedIn Corp. (LNKD) and Netflix Inc. (NFLX) flying, while select chain retailers and consumer-staples names have been under pressure. Investors adore sports-gear makers Under Armour Inc. (UA) and Nike Inc. (NKE), placing them near all-time highs, but have lost patience with LuluLemon Athletica Inc. (LULU), which is hurting in Thursday trade following weak guidance in its earnings report. Interest-rate-linked financial shares are holding up nicely while rate-sensitive utilities have wilted; car stocks are peppy but homebuilders sluggish.
For quants and wonks, the nearby chart depicts something called the CBOE S&P 500 Implied Correlation Index, which tracks the options market’s expectation for how closely individual Standard & Poor’s 500 index members will hew to the index itself. While some quibble with the technical underpinning of this index, it’s clear that stock correlation has been in a steep downtrend since peaking in 2011.
Mike Block, strategist at Rhino Trading, points out this gauge of stocks’ linkages hasn’t been this low for any stretch of time since late October 2007, right after the prior bull market peaked.
Nick Colas, chief market strategist at institutional broker ConvergEx Group, takes a monthly snapshot of how industry sectors and various other asset markets are acting relative to one another. In the latest look, such correlations were “meaningfully lower than historical post-crisis norms.”
He suggests that analysts and investors charged with outrunning a benchmark should grab “a sharp pencil” and start looking for ripe ideas within the indexes. “While stock markets will certainly remain choppy in the near term,” he offers, “the opportunities for active management look to be in their own very early ‘bull market.’”
Such an environment would lend a tailwind to mutual funds with high "active share," or a tendency to take bets that deviate appreciably from standard benchmarks, such as Jensen Quality Growth (JENSX), Oakmark Select (OAKLX) or Fidelity Contrafund (FCNTX).
Colas notes that quantitative-investing models are picking up this trend of lower correlations among stocks, reading it as a sign of ebbing risk levels, which would lead them to raise allocations to equities.
There are a few things at work here, most of them constructive.
The smothering blanket of macroeconomic and systemic uncertainty touched off more than five years ago in the credit bust and crisis has finally lifted since late 2012 – at least for now. Expectations of slow-ish but positive growth and market confidence in the resolve of central banks to liquefy the system have become rooted, freeing investors from the taxing “risk-on/risk-off” toggle that prevailed for most of the past half-decade.
The anticipation of the Federal Reserve stepping back from its monetary stimulus efforts, whether next week or in coming months, has prompted a lift in market-set interest rates and led to a separation of winners and losers from a slightly higher cost of money. Yield-hog plays such as utilities and REITs have been punished, while growth-levered companies have been bid up.
And, finally, the corporate profit cycle is quite mature, with margins hovering near historical highs, so investor dollars are increasingly flowing toward companies perceived to have sustainable earnings-growth potential. Thus the emergence of a narrow elite of growth darlings leading the market, including the social-media names, Starbucks Corp. (SBUX), Gilead Sciences Inc. (GILD) and Walgreen Co. (WAG).
In other words, the stock-picker’s market is another way of characterizing a maturing bull market acting like a bull market.
Yet this pattern is not entirely welcome to all. For one thing, it means it’s become easier to be in the “wrong” stocks or sectors and underperform the sturdy indexes. And the multitudes who now rely on index ETFs for market exposure won’t benefit as much, as variations in stock performance create offsetting forces.
Finally, the kind of calm and confidence that accompanies lower correlations is one feature of markets that have become a bit too complacent. Of course, things can stay this way for a prolonged period of time, and indeed they did in the latter stages of the 2003-2007 bulls’ run. But they might not. Historically, heightened correlation, which suggests extreme risk aversion, has made for better buying opportunities for risky assets.
Block, citing the dramatic drop in the correlation index since last year’s highs, asked in a client note this week: “Have we come too far to the downside? Are all of the world’s problems solved? Perhaps they are enough to get us here. But we have the Fed next week. Earnings season is a few weeks away. Emerging markets are playing Baccarat with their reserves. A lot can still go wrong. I remain bullish in the intermediate term but if I am lightening up here, this is why.”