Over the last few days we’ve been tempted to call the current US equity investment environment “The Seinfeld Market” – a show about nothing.Despite a series of oddball macro antics over the last month, the S&P 500 is basically unchanged. Every episode/trading day starts with some unexpected catalyst (trade, rates, whatever scheme Kramer is plotting), but over time the characters/stocks just end up right where they started.
Aside from May’s slide and June’s symmetrical recovery for US large caps, the only evidence anything has actually “happened” in our market-as-sitcom is a notable bout of higher asset price correlations. We have tracked these on a monthly basis for the last decade because:
- S&P sector correlations to the index itself are a good measure of fundamental market health. When the average industry correlation to the overall market is +0.8, as it was for years after the Financial Crisis, it means investors are treating equities as a single risky asset class. When they drop below that level, you know investors are actually allocating capital on the merits of each sector’s fundamentals.
- The correlation between different asset classes and stocks also shows when/where macro concerns are rising. When gold’s correlation to stocks goes deeply negative, that’s a sign investor confidence in financial assets is low. When high yield corporate bond correlations to stocks rise, it means investors are worried about an imminent recession since that would crimp business earnings and cash flow.
- High correlations leave equity markets susceptible to greater volatility since the benefit of diversification mathematically declines.
Here are our 3 observations from the latest correlation data:
#1: The last month, as volatile as it was, was not as bad as Q4 or last year’s choppy February – April period, but higher-than-normal correlations/volatility don’t disappear after just 1 month.
- The average trailing 30-day correlation for the 11 sectors of the S&P 500 to the index is 0.74 just now.
- Q4 2018’s average was 0.80 and February – April 2018’s mean was 0.83.
- Across recent history, sector correlation averages of 0.75 or above tend to come in threes (i.e. once you get one, you’re likely to see the next month or two remain high).
Takeaway: the current correlation reading is right at the cusp of where you’d expect to see some further volatility.
#2: Higher correlations across some asset classes (but not others) shows that capital markets were more worried about Fed policy over the last month than trade wars.
- EAFE (non-US developed economy) stocks and high yield corporate debt both saw higher correlations to US stocks last month at 0.90 and 0.92, respectively. Prior month readings were 0.87 and 0.59 respectively.
- Emerging Market equities actually saw their correlation to US stocks decline over the last month, from 0.78 in May to 0.63 today.
Takeaway: for all the focus on US-China trade, one would have thought the EM/S&P correlation would be higher. Over half of the MSCI Emerging Markets equity index is Greater China, after all. But no. Which leads us to conclude that markets were much more concerned about Fed policy, as they were in Q4 2018.
#3: Even though gold has had a good run in the last month – up 3.1%, basically its entire gain for 2019 – that’s not because it has become more/less correlated to stocks.
- The trailing 30-day correlation between gold and the S&P is -0.27.
- While higher than the 3-month average of 0.02, it is similar to April’s reading of -0.24.
Takeaway: gold’s correlation to stocks tends to average zero unless there is real financial stress in the system. This month’s reading is within normal bands.
Final thought: this month’s correlation data supports our basic call that US stocks will remain volatile for the next 1-3 months. The last 30 days shows that isn’t necessarily a cause for concern, however. Nothing much happened on Seinfeld for 9 seasons either, and people still watched.