Out-of-sync U.S. stocks hide market risks
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[July 05, 2023] By
Saqib Iqbal Ahmed
NEW YORK (Reuters) - U.S. stocks' tendency to move in sync has plunged
to near-record lows, but what might seem like a stock picker's dream may
actually be a mirage, and investors may be in for a rude awakening.
S&P 500 correlation - a gauge of herd behavior, which measures how
closely daily returns of index constituents align over a month - slipped
to 0.22 at the end of June, close to the lowest since November 2021,
according to data from S&P Dow Jones Indices. That means that many
stocks are moving in different directions.
Investors expect stocks to move increasingly out of sync as shown by the
Cboe 3-Month Implied Correlation Index, which measures the 3-month
expected average correlation across the top 50 value-weighted S&P 500
stocks. The Index touched a record low of 17.59 on Wednesday.
That would typically lower risk and offer more opportunities for stock
pickers. But with the bulk of the market's gains being driven by a
handful of mega cap names and a crowd of market bets on continued low
correlation, investors may be relying on a false sense of calm.
"The risk metrics that look quiescent and favoring idiosyncrasy may in
fact be a chimera much more vulnerable to a macro shock than implied
currently," said Arnim Holzer, global macro strategist at EAB Investment
Group.
History suggests such narrow breadth can set the market up for a sudden
surge of volatility.
"From these low levels of stock correlations, equity volatility has
historically risen," UBS strategists said in a note on Wednesday.
The Cboe Volatility Index, the so-called Wall Street 'fear gauge,' which
recently closed at it lowest in nearly 3-1/2 years, has generally jumped
by 10 points over the coming quarter when 1-year stock correlations have
been at the current low levels, the strategists said.
The last time 3-month implied correlation got this low was in early
2018, just before the February 2018 urge in market volatility dubbed 'Volmageddon.'
The low correlation now is in stark contrast to late last year when
investors were laser-focused on macro factors including employment,
growth and inflation, leading stocks to move in sync.
This year, however, with the U.S. Federal Reserve close to the end of
its hiking cycle, economic data has lost some of its ability to sway
stocks en masse.
Much of today's low stock market correlation has to do with the gulf in
performance between a handful of mega caps driving the benchmark index
higher and the rest of the market.
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A specialist trader works inside his
post on the floor of the New York Stock Exchange (NYSE) in New York
City, U.S., March 10, 2022. REUTERS/Brendan McDermid
While the S&P 500 has gained 16%, its equal-weight equivalent, which
dilutes the impact of the largest companies in the index, has risen
just 6%.
That leaves less room to pick winners.
"You have this view in the market that this is a stock picker's
market because correlation is low," EAB Investment Group's Holzer
said.
"The problem is that this is not that environment," he said.
For some investors, it also means thinking outside of large caps.
"Given the narrowness of the market so far this year, we suggest
investors consider an S&P equal-weight strategy or U.S. mid-caps for
cash earmarked for U.S. large caps," said Jack Ablin, chief
investment officer of Cresset Capital.
"History suggests the average stock will 'catch up' with the mega
caps over the next 12 months," Ablin said.
COILED MARKETS
One trade that has drawn investors in recent months is the so-called
long dispersion trade - where traders sell index volatility while
buying volatility on constituents - essentially betting on
individual stocks not being strongly correlated, Kris Sidial,
co-chief investment officer of volatility arbitrage fund the Ambrus
Group.
This, in addition to general selling of volatility as markets
skipped higher this year, has crushed volatility and correlations.
"It's a big pile-on into short volatility and short correlation,"
Sidial said.
But that also sets up the stage for a rapid upheaval when the calm
breaks.
"When you have one side of the market that has piled into a trade,
when that trade unwinds, it can be very rapid," he said. said.
For investors, the pricing on index hedges that would guard against
a big jump in volatility is more attractive than it has been for a
while.
"Because correlations are so low, index options have gotten
incredibly cheap," said Daniel Kirsch, head of options at Piper
Sandler said.
(Reporting by Saqib Iqbal Ahmed; Editing by Megan Davies and Nick
Zieminski)
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