The concept of tracking the dispersion of stocks via a correlation reading may be a bit intimidating. However when broken into layman’s terms, the principle doesn’t involve a lot of grey matter. Correlation within the S&P 500 stock index measures the degree to which all 500 stock constituents are moving up or down together. A high correlation means all 500 stocks are trading within a narrow band of each other and hence are appreciating or depreciating together in fairly uniform percentages. A low correlation, means that stocks are moving more independently of each other, which means there is a wide variation of stock price movements within the index itself. Generally, a lower correlation is better for increased fund flows and potentially higher markets, a situation which is unfolding now.
Currently, correlation as tracked by the Chicago Board Options Exchange has cascaded sharply from a high of 87.0 in December of 2011 to the current reading of 60.8 in January to start 2013. As mentioned above, a lower correlation environment is better for stock picking and fund flows because the dispersion of stock returns is wider and hence professional money managers have a better opportunity to outperform a benchmark. For example, when correlations are high, the return of all stocks is fairly similar so it is difficult to produce returns higher than the index. This situation is most common in challenging markets where investors are simply making big asset allocation moves between stocks, bonds, and cash. The skittishness of investor decisions then results in a huge rush into stocks, then into bonds, then into cash, and all the returns within these asset classes are fairly similar. On the contrary, when correlation is breaking down, it is usually a sign of strength for stocks because investors have allocated assets to the stock category and are now becoming more discriminant about which stocks they are buying. This is usually indicative of a Bull market which is where market signs are currently now.
Mutual funds and ETFs versus the S&P 500
While U.S. mutual fund flow has not been a great data set to analyze due to the secular losses in fund flow to exchange traded funds (ETFs), the current decline in correlation is showing up in U.S. equity mutual fund flow numbers. As shown above, directionally the continued decline in correlation in the first quarter of 2012 did improve mutual fund flow during that same period as managers had the chance to put up stronger returns than the indices. Most recently, the continued sharp drop in correlation to recent lows has also spiked mutual fund flow to start 2013.
While correlation is a more esoteric principle to be familiar with, the continued decline of stock dispersion in the S&P 500 is good for stock returns and hence fund flow and potentially higher market levels. The asset managers most to benefit from higher equity fund flows would be T Rowe Price (TROW), Invesco (IVZ), and Janus (JNS) who manage leading equity mutual fund franchises. Generally, broader stock markets tend to outperform as well in a lower correlation environment which makes the case for State Street’s S&P 500 ETF (SPY).