Timely research from Nomura, this. The global strategy team took the top 500 large-cap stocks in the developed world and ran a couple of tests, and found:
| - Recent low-volume market rallies have been more likely to be sustained for longer, while high-volume rallies have seen more reversals. - We have seen the fastest fall in correlation so far in 2012 that we have ever seen. - Falls in correlation such as this tend to be supportive for market returns. - This also increases the potential return to be earned from stock-picking and we can show that such falls tend to directly lead to greater inflows for active strategies. ... We think that the fall in correlation and low volume of the rally so far support further equity market outperformance. |
January 2012 is a volte-face from Q4 last year:
| Correlation reached an all-time high in Q4 2011, surpassing the previous peaks in 1987, 2008 and 2010. However, the rotation within the market since the beginning of the year has taken this down to a level that is low in the context of recent years. |
The story in pictures:
By late-September 2011, market correlations - by geography and asset type – in the main intensified with a broad-based sell-off across global equity markets and EM currency markets, in particular, as the Greek debt saga and concerns over a double-dip recession in OECD economies took their toll. Correlations between the MSCI DM and EM rose to 0.94 between August and late-September (though Asia outerperformed). However, US stock correlations hit record highs of near the perfect value of one.
So what does this recent fall in US stock correlations signal going forward: (Emphasis ours)
| Falling correlation tends to be supportive of equity index levels. The level of correlation has tended to have a negative correlation with index levels over several decades. However, we think it is most relevant to focus in on the last two large peaks in correlation in 2008 and 2010 as they have the most similar characteristics to the recent elevated level oaf correlation. Correlation fell sharply from both these peaks. ... the equity rally that occurred over the time that it took 75-day correlation to fall from peak to trough in these last two cycles, in this case for the global market. Here we focus on 75-day correlation as it has the best relationship with market returns. Although the market response so far this time has been similar to that which we saw in 2010, the fall in 75-day correlation so far has been much smaller and the peak level reached was higher. The abrupt fall in 25-day correlation we think means that 75-day correlation will follow, which should be supportive of future equity returns. |
Why is there an asymmetrical relationship in correlation levels and market performance i.e. when correlations are high, markets fall but when correlation levels are low, markets remain largely range-bound in a given period, roughly-speaking.
Inigo Fraser-Jenkins, global equity strategist at Nomura, explains to Emerging Markets:
| During market falls, correlations are sharper since people are often forced to sell and markets are generally less discerning over the fundamental value of stocks. |
In short, the January rally in US stocks still has legs, if history is any guide, thanks to a virtuous mix of low correlation and low volume of the rally - unless the eurozone crisis intensifies, of course -, says Fraser-Jenkins.
This is important for EM stocks. While the global investor base for bonds is more divided between EM-dedicated and developed market-focused investors, a large number of global equity funds are benchmarked to the MSCI All Country World Index, which incorporates both developed and emerging countries. As a result, the debate about the relative value of EM equities over DM stocks is crucial. Indeed, expectations of US stock outperformance was one reason why investors chose to allocate there at the expense of emerging markets, triggering the underperformance of the asset class between October 2010 and late-2011.
Although the Nomura team is still overweight emerging markets – buoyed by monetary juice, attractive prices and better corporate earnings – the relative value of EM and US stocks might be a theme to watch, for some investors.