Summary

  • Stock correlation is often the enemy of the active investor. When correlations are high, most stocks trade in the same direction, offering diminishing opportunities for outperformance through security selection.
  • For example, in 2008, nearly all stocks declined – correlations were high – and stocks were differentiated only by how much they fell. Active managers could outperform by owning stocks that went down less than the market, but there were precious few stocks that actually rose for the year. Ultimately, mutual fund performance came down to how much cash PMs carried, and for the hedge fund crowd, how many short positions the PM carried (and stuck with).
  • The following year, 2009, also had high correlations, but in the opposite direction – nearly every stock rose. Some rose 10%, some rose 100%, but there was little long-short spread to be had on an absolute basis.
  • On the other hand, markets with low or declining correlation and high dispersion present active managers with opportunity – some stocks decline while others rise. “Stock-picking” can pay off during such periods, and long/short strategies can really pay off, especially on a risk-adjusted basis. One of those times is upon us now.
  • Dispersion in the U.S. equity markets is currently declining from Q1:2020s’ ten-year high in correlation, when nearly 80% of stocks did the same thing – they declined. Opportunities abound.

The CBOE’s S&P 500 Implied Correlation Index (KCJ Index) is a decent rule-of-thumb for measuring the availability of “stock-picking” opportunities. It measures the expected average correlation of price returns of S&P 500 Index components, implied through S&P 500 index option prices vs. prices of single-stock options. In other words, it compares the options premiums to isolate the market risk from the stock risk. This gives us an idea of how much market correlation is “implied” in these stocks.

The KCJ reached 78 during March 2020 before retreating to its current level of 60. The long-term median is 55. Clearly, Covid and the current recession is affecting each company differently. There are massive beneficiaries, for example, telemedicine vendors, remote videoconferencing companies and e-commerce players. And then there are companies facing bankruptcy such as car rental companies. The opportunity for active managers to invest in one and not the other (even better, buy one and short the other) is the best it’s been in 5 years.

Sector Example – Dispersion: Technology Stocks vs. Financial Stocks
Like the rest of the market, tech stocks fell during Q1. But their rebound since has been much stronger than other sectors.

Subsector Example – Dispersion: Financial Technology vs. Regional Banks
Peeling back another layer of the onion, we can see the fintech stocks massively outperformed bank stocks during the Q2 rebound to date. We expect this trend to continue. Fintech companies are the #1 threat to the staid banking franchises which have morphed into utility-type operations since the GFC. They are cheap, but for good reason. No growth, and a Mother-May-I type of relationship with their regulators and federal overseers.

Stock Example – Dispersion: PayPal vs. JP Morgan
An extreme example is the marketshare gains of deposits and transaction volume of PYPL vs. JPM. The stock prices reflect underlying fundamentals.

Tech vs. Financials, Fintech vs. Regional Banks and PYPL vs. JPM are terrific examples of the dispersions available to the forward-looking investor. See our Thematic Investing and Pair Trades sections of our R&D tab for additional analysis.

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