Correlation Collapse Cause For Corrective Concern

Intra-stock correlation of the top 50 market cap names has plunged in the past month. As Citi’s Tobias Levkocich warns that suggests that investors might be overly focused on stock picking and have begun to ignore broader influences such as Fed policy, market valuation, European growth trends, economic surprise indices and the like. As performance issues have forced some investors into higher beta areas in order to boost outcomes, one would think that a more precarious correlative environment such as this would imply taking down more aggressive portfolio risk. Given today’s ramp in builders and transports, that appears a far flung idea for now…

 

 

Via Citi,

Intra-stock correlation of the top 50 market cap names has plunged in the past month. Investors look to be at risk given the collapse of intra-stock correlation from 66% at the end of June to just 18% at the month’s end in July which suggests that investors might be overly focused on stock picking and have begun to ignore broader influences such as Fed policy, market valuation, European growth trends, economic surprise indices and the like. Very high readings on intra-stock correlation tend to generate an intriguing buy signal as seen in September 2011, while low levels suggest a degree of complacency that puts fund managers at risk for a correction.

 

Macro concerns should never dominate the discussion, but they should not stop mattering either. Investment professionals should not place an excessive emphasis on macro data or their proponents, such as economists and strategists, but ignoring their insight is also a risky move. For instance, the aggressive company-driven analysis done in March/April for dividend growers in order to take advantage of the search for yield was highly disrupted by the backup in Treasury bond yields during the May/June time frame. Hence, ignoring macro conditions can lead to portfolios getting upended.

 

A pullback on beta seems appropriate. As performance issues have forced some investors into higher beta areas in order to boost outcomes, one would think that a more precarious correlative environment would imply taking down more aggressive portfolio risk at this juncture. Accordingly, investors might prefer large caps and less Diversified Financials exposure in the near term.

In other words, the performance is being driven by fewer and fewer larger and larger performance aberrations in headline stocks – which won’t end well.

    

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