How Healthy Is The US Equity Market, Really?

How do you judge the health of a stock market? A few ideas we’ve heard over the years and why we disagree:

  • Does it generate decent long run (+10 year) returns? A tempting answer, but that’s more about the companies listed than the market itself. Lousy long term results are just markets reflecting harsh reality. Don’t blame the messenger…
  • Is it volatile? This is more likely to be the result of macroeconomic factors, not market health. As with the prior point, markets simply reflect back to society the results of its choices on fiscal/monetary policy as well as other issues like financial system regulation and the propensity for ill-informed investors to create asset bubbles.
  • Do exciting new companies choose to go public? If markets are healthy, the thinking goes, we should see lots of initial public offerings. The problem here is that other capital sources like venture funds and private equity compete with public markets. And over the last 10 years, they have done so with ruthless efficiency. So public markets can be “healthy” and still lose out to other funding sources with unique value propositions for business owners.

Our own admittedly geeky answer is “Correlations”. Here’s why:

  • Public markets should allocate societal capital to its best possible use. Good companies should see rising stock prices and bad companies should wither.
  • Over time the signaling effect of this disparity will give the better company more options to expand, employ better workers (partly paid with more valuable stock options) and deploy scarce capital. The poorly run company will either sell itself to one of its better-run competitors or go by the wayside.
  • The same applies for industry sectors. Capital is finite, and areas of the economy that can use it better should see their stock prices perform better. That may not seem fair if you are the best run company in a bad sector, but that’s the way it goes.

This is why we have looked at US sector correlations to the S&P 500 on a monthly basis since 2009, and the data shows a clear trend when it comes to the health of the US equity market since the Financial Crisis:

  • Very unhealthy: 2009 to 2011. The average correlation between the 10 sectors of the S&P 500 was 0.87 over this period, with many months over 0.90. Normal ranges are 0.50 – 0.60. The reason for this herd mentality: investors were focused on global central bank policy coming out of the Financial Crisis rather than specific industry fundamentals.
  • Improving health: 2012 – 2016. The average S&P sector correlation over this period fell to 0.80. That may not look like a large drop versus the prior period’s 0.87, but the trend to lower correlations took time to develop. Bouts of volatility caused them to spike, but every calm period saw slightly lower average sector correlations than the previous one.
  • Healthy, with a few relapses: 2017 – 2019. Sector correlations have averaged just 0.63 over the last 2 years and almost 3 months. For readers with a statistical bent, the r-squared comparison versus 2009 – 2011 tells the story: 76% then, 40% now.

Pulling this discussion into news-you-can-use with two final points:

#1: S&P sector correlations to the index were 0.65 over the last 30 days, right in line with the 2017 – 2019 average. We expected to see a higher number given last week’s selloff; correlations typically rise when markets drop.

This is good news for two reasons.

  • First, it shows that US stocks have not reverted to their post-Crisis high correlation form despite worries over US-China trade negotiations and slowing global economic growth.
  • Second, the most recent reading of 0.65 is much lower than mid-January (0.88) or mid-February (0.73). Given that the S&P is +1.7% over the last month, this shows that the last 30 days hasn’t just been a mindless snap-back rally from the December 2018 lows. Investors/traders are differentiating between sectors more than earlier this year.

#2: Correlations deeply inform volatility, which is a key reason that the CBOE VIX Index couldn’t breach 20 (its long run average) during last week’s selloff. For those readers who use the VIX to trade near-term lows, this is important. Lower correlations mean less actual volatility (the math of diversification) and that leads to lower implied volatilities in options prices (what the VIX actually measures).

Summing up: we’re surprised US sector correlations are so low just now, but happy they are. It’s good for active managers, who have a better chance to outperform without taking outsized bets. It’s good for investors generally, since lower correlations mean lower volatility. Best of all, low correlations show a healthy equity market. That’s only been the case for a little over 2 years, and we hope it continues.

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