Are most stock charts starting to look the same to you lately? If so, there’s a good reason – last week, the Financial Times reported that correlations among individual stocks have reached their highest level since 1987.
Citing a study conducted by JPMorgan, the FT noted that the correlation among the largest 250 stocks in the S&P 500 has reached 81%. The only time this number came in higher was during the 1987 stock market crash, when it topped out at 88%. Typically, the correlation is closer to 30%. The result is that it’s increasingly difficult to add value through stock picking in the large-cap space — but that doesn’t mean it’s impossible.
A look through the charts shows that the cyclicals have been most tightly correlated with the S&P during the past three months, which makes sense, given that the fear of a global recession has been the primary factor moving the markets during that time. Using the major S&P sector exchange-traded funds as a proxy, the five sectors with the highest degree of cyclicality are trading very tightly with the S&P 500. The chart below measures the Energy Select Sector SPDR (NYSE:XLE) ETF with the S&P 500, but if you compare the index to the industrials, materials, consumer discretionary, and technology sectors, the picture is essentially the same: In most cases a trade in one of the large-cap stocks in these sectors is largely a broader-market bet until further notice.
Looking overseas hasn’t a viable option either, which isn’t surprising when Europe is the epicenter of the current problems. Both the iShares Trust MSCI EAFE Index Fund (NYSE:EFA) and iShares MSCI Emerging Markets Index Fund (NYSE:EEM) have lagged our market by a wide margin in the past three months, and very few single-country ETFs are outpacing the S&P. For now, it looks like investors are better off keeping their money at home.
That leaves the more defensive areas of the U.S. market for stock-specific opportunities, but even here the pickings are slim. The Health Care Select Sector SPDR (NYSE:XLV) ETF has been as tightly correlated with the S&P as the more cyclical market segments, and a search through the charts of the largest companies in the group finds Abbott Labs (NYSE:ABT) Bristol-Myers (NYSE:BMY), and Allergan (NYSE:AGN) among the few stocks showing any meaningful, positive divergence from the broader market.
While health care doesn’t make the cut, two other defensive sectors do: utilities and consumer staples. In utilities, some of the leading relative performers during the past three months have been Southern Cos. (NYSE:SO), Consolidated Edison (NYSE:ED), Duke Energy (NYSE:DUK), NiSource (NYSE:NI), and Constellation Energy (NYSE:CEG). They’re boring, no doubt, but at least these stocks have offered investors yield and a safe harbor at a time of trouble.
Here’s a chart of the Utilities Select Sector SPDR (NYSE:XLU) ETF:
Consumer staples also have proven to be an area that has featured both outperformance and lower correlations. Naturally, a high level of selectivity is in order given the high overseas exposure – and the threat of a rising dollar – faced by many companies in this group. Still, it has been home to a number of large-cap stocks that have bucked the broader market trend in recent months, including Coca-Cola (NYSE:KO), Kraft Foods (NYSE:KFT), Altria (NYSE:MO), and Colgate-Palmolive (NYSE:CL). Not surprisingly, all of these stocks sport yields above that of the S&P 500.
Here’s the Consumer Staples Select Sector SPDR (NYSE:XLP) ETF:
No matter how compelling a stock idea might be, the majority of large-caps are just extensions of the broader risk-on / risk-off trade until correlations begin to normalize. The Financial Times article quotes a recent Goldman research note that stated, “While we expect that the correlation level will remain generally high in the market, we would expect reduced correlation as we enter the third quarter earnings season in October and investors refocus on company fundamentals.”
This is probably spot-on, since it’s hard to picture anything but the macro trade capturing traders’ attention in the near future. Alcoa (NYSE:AA) kicks off the next earnings season on Oct. 11, which leaves another four weeks for investors to wring their hands over the problems in industrialized economies.