Correlations Show A Brittle Market

By admin_45 in Blog

In a blow to data nerds everywhere, Google is shutting down its Correlate online analytical tool in December. Using history back to 2004, Correlate shows words and phrases whose volumes peak and trough at the same times as a given search term. For example:

• Google searches for “stock market” strongly correlate with “dow market” (0.91), “the dow” (0.89) and “market crashes” (0.89). 
  
  This is why we look at Google searches for “dow jones” to assess how market volatility may be affecting consumer confidence. Main Street doesn’t care about the S&P 500.
  
  
• Searches for “Apple” are highly correlated with queries for “is the iphone” (0.85), “sale iphone” (0.84) and “price iphone” (0.84).
  
  As we discussed on Sunday night, Apple’s challenge now is to shift from being a smartphone company to a services business. In the minds of consumers, it is only the former just now.
  
  
• Searches for “buy a house” correlate well with “marry someone” (0.91), which speaks to one fundamental driver of household formation.

While Google is sunsetting Correlate due to what it says is “low usage”, stock market correlations remain front and center in investors’ minds. We’ve been running monthly asset class/sector correlation analyses since the Financial Crisis, and last month’s data was pretty surprising.

Three points that really stood out to us:

#1: While the S&P 500 is +4.0% over the last month, sector (Tech, Financials, Industrials, etc.) correlations averaged 0.87, which is notable because:

• That’s the highest reading since December – January, when the market swooned and recovered as the Fed pivoted on rate policy. When equity price volatility spikes, so do S&P sector correlations. And vice versa, of course.
• It is only the 3rd month since the 2016 US elections where sector correlations were over 0.85, and the first time where rates/market structure were not the chief cause.
• The chart below shows the October 2009 – present monthly history of average S&P 500 sector correlations, and the break after President Trump’s election stands out clearly. The only +0.85 readings since then were the volatility-product ETF meltdown/aftermath in Feb – April 2018 and the aforementioned year-end 2018 volatility.

Conclusion: Global recession fears, headlined by US-China trade war concerns, hit a tipping point last month with correlations tightening up almost as much as if the Fed was about to make a policy mistake or markets “broke”. Even if defensive groups showed lower-than-average correlations (Utilities 0.54, Real Estate 0.64), most groups are economically sensitive enough to see their correlations rise when economic uncertainty climbs.

#2: Correlations between US equities and international stocks have also been extremely high over the last 30 days:

• The price correlation between MSCI EAFE (non-US developed economies) and the S&P 500 was 0.94.
• The correlation between MSCI Emerging Markets and the S&P 500 was 0.91.
• To put some perspective around those numbers, EAFE stocks traded more like the S&P 500 than large cap US Financials (0.93 correlation) and Emerging market equities mirrored the S&P more than US Energy stocks (0.88 correlation).

Conclusion: geographic diversification did nothing to shelter portfolios from volatility, which makes sense given the prior point.

#3: The correlation between long-dated US Treasuries (+20 years) and stocks hit negative 0.66 over the last month, a remarkable reading:

• It is more pronounced than any month during the early 2018 volatility product storm (-0.39 to -0.54).
• This reading is also more negative (i.e. better diversification) than June 2019 (-0.57), when stocks retreated and bonds rallied.

Conclusion: bonds did a fantastic job of diversifying portfolios over the last month – one of the best 30-day periods on record, actually.

Final takeaway: the extremes here – very high equity sector correlations, strongly negative bond correlations – say that markets are dancing in between the proverbial raindrops of a possible trade-war related global recession. Good news, therefore, that US-China trade talks appear to be back on track. At the same time, August was a sign that investor confidence is wearing very thin indeed.