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The Science of Hitting
The Science of Hitting
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Equity Correlation - A Positive Development for Investors

July 09, 2012 | About:

In Monday’s Financial Times, there was an interesting article discussing the high correlation among equities; as noted in that piece, the one-month correlation between individual S&P 500 stocks reached 90% in October of 2011 (as the market was suffering bouts of extreme volatility), compared to a historical average of just 30% since 1990.

One explanation, as pointed out in the article, is an increased focus on passive management; according to Goldman Sachs (GS), passive equity funds in the U.S. have grown 24% a year since 1995 compared to just 8% per annum for active funds – resulting in a jump of passive managers’ share of all U.S. equity assets from 5% to more than 25%. In addition, ETFs (as opposed to individual securities) have become the vehicle of choice for many investors and have had an astounding impact on trading: According to Goldman, the U.S. ETFs that are indexed to the S&P 500 have volume nearly equivalent to the trading of all 500 individual securities.

While the seismic shift in the use of ETFs is relevant (and a partial explanation for the lock-step among equities), I think the key insight comes from the correlation figures, which tend to spike during times of market stress – as seen during the Asian Crisis of 1997, the LTCM Crisis of 1998, and the euro zone crisis, which began in the back-half of 2009. As noted in the article, correlations have a tendency to peak when ERP’s (equity risk premiums) are at their highest – in other words, when stocks are most attractively priced in comparison to bonds.

I find this most ironic because of the two key conclusions that can be taken away from the data; the first is that investors are largely focused on macroeconomic events rather than company-specific fundamentals (thus the focus on asset classes vs. individual names), and jump in and out of stocks based on the near-term headlines. I continue to find that individuals are much better at repeating what great investors have said rather than actually implementing their advice; as Peter Lynch once said in a PBS interview, this is essentially a fool’s errand:

“I don't remember anybody predicting [that in] 1982 we're going to have 14 percent inflation, 12 percent unemployment, a 20 percent prime rate, you know, the worst recession since the Depression. I don't remember any of that being predicted. It just happened. It was there. It was ugly. And I don't remember anybody telling me about it. So I don't worry about any of that stuff. I've always said if you spend 13 minutes a year on economics, you've wasted 10 minutes.”

The second thing that draws my attention to this data is a famous quote from Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.” While this goes against my first point, I think one should focus on these macroeconomic developments, particularly during periods of high correlation – only because I think this is a great contrarian indication of how one can do just that – be greedy when others are heading for the hills. When everyone is focusing on everything besides a company’s fundamentals, the value investor should be giddy.

My favorite example of this is the incessant focus on commodity costs, and how they will hit near-term profits; while this likely won’t surprise anyone, Procter & Gamble (PG) isn’t successful because of its propensity to time changes in commodity prices. This is nothing more than noise that is blocking investors from focusing on what really matters: innovation, brand equity, distribution and other competitive advantages that have made P&G the behemoth it is today. As always, I think investors should ask one simple question: Has the company’s competitive advantage been diminished, or is this simply a distraction from what determines the long-term winners and losers of the industry?

The focus on commodity costs and who can navigate them with the most benefit to their near-term EPS is a sideshow that distracts true owners, because it’s all a wash at the end of the day. As Warren Buffett (BRK.B) likes to say, he would prefer that Burlington Northern didn’t bother with hedging/smoothing earnings due to the long-term net cost of doing so (all the gains and losses cancel over time, with the company left paying the premiums on the contracts); if the managers knew otherwise and could profitably hedge their exposure, they should simply sell the railroad company and spend their time trading commodities.

My bet would be that significant correlation among equities is here to stay, at least in the near term; the focus continues to be on macroeconomic developments, and equities will collectively trade in anticipation and in reaction to developments around the globe (regardless of whether companies have any exposure to the regions in question). For active investors, this is an opportunity to buy great businesses as they gyrate along with the major indices; for those focusing on company specific fundamentals, it continues to be (as it always has been and will be) a great time to own sound businesses at attractive valuations.

About the author:

The Science of Hitting
I'm a value investor with a long-term focus. As it relates to portfolio construction, my goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach to investing is "patience followed by pretty aggressive conduct". I run a concentrated portfolio, with a handful of equities accounting for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 4.2/5 (19 votes)


Marcolanaro - 5 years ago    Report SPAM
You are absolutely right, macroeconomic headlines are just a big distraction. Thank you, another great article!
The Science of Hitting
The Science of Hitting - 5 years ago    Report SPAM

Thanks for the compliment!
Stephen Neumeier
Stephen Neumeier premium member - 5 years ago
On the other hand, I can think of a number of people who forecast the housing bubble popping.

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