Thursday, March 13, 2014

Correlations and Opportunity Sets in the Stock Market

Here's a chart of rolling correlations among the major sectors of the S&P 500 stock universe vs. the S&P Index (SPY) itself.

Whether we are in a more correlated or less correlated environment impacts the relative value of trading the index itself vs. stock picking within the index.  Most recently we've been in a lower correlation mode.  Indeed, as we see from the FinViz site, over the last three months, returns from the major sectors have varied from a high of 10.1% (healthcare) to a low of -17.4% (conglomerates).

As a rule, the sectors tend to become more correlated during moves down and initial rises from lows and then less correlated during periods of short-term topping.  It is during those topping processes that we see sector rotation and weaker sectors falling off while stronger ones hold their highs.

My longer-term correlation metric has increased from .65 during 2005-2006 to .80 for 2012-present.  That has been part of the stockpicking challenge in the large cap universe and (along with volatility and its collapse) is one of the reasons many short-term traders in the stock market have gravitated to smaller cap shares that move more idiosyncratically.

It's yet another illustration of how market environments can shift over time and impact opportunity sets for traders.

Further Reading:  Adapting to Change