We have witnessed some of the highest levels of stock correlations for years both in developed and emerging markets. Correlation can be defined as the closeness of returns by two individual stocks or a stock and market. Markets are described as having high correlations if, when one market is affected by a particular event, others react too.
In July, Birinyi Associates showed US stock correlations to be the highest since the October 1987 crash.
This appears to be related to persistent uncertainty over macro fundamentals. Markets show little reaction to stock-specific news while risk premia remains relatively high. One conclusion is markets are not as discriminating as they might be between high and poor quality companies.
Global equity indices seem to move together regardless of quality of a country’s fundamentals. One argument is this reflects macro uncertaintyand will not reduce until there are clear signals the macro-economic picture is improving.
Data indicates an improvement is under way but its persistence has been low or contradictory. The decision to increase or decrease exposure to risky assets drives stock returns much more than investors’ reactions to news about companies or countries. If this low level of cross-sectional stock dispersion were to persist, this implies the rewards for successful stockpickers could be less obvious. Market liquidity is much tighter than you might think, so it might not be easy to implement a manager’s desired change in direction.
At the margin, a recurring observation has been traditional value managers buying into or owning stocks that are more typically favoured by growth-oriented managers. In managing funds of funds, the implications are tricky to deal with since it may imply owning fewer assets or equity funds, thus being less diversified because of the lower probability of out-performing policy benchmarks after costs.
An alternative is to trade positions much more actively since the returns to markets have become more range bound for a variety of styles but this requires a high level of precision and, like direct securities trading, comes at a cost.
The third way is to trade the asset allocation more actively or hold more asset classes, particularly physical assets such as commodities and property.
An appetite for trading seems to chime well with what is materialising in the real world on a much grander scale. Free cashflows are high and, in theory, they could reinvest in current portfolios at high rates of internal return. In the absence of capital expenditure, the response to the above may be why dividend growth rates are healthy again and suggests a good valuation underpinning for quality growth stocks.
This is a growing theme in the UK. The other is that lower stock prices are drawing out M&A activity. The targets have been quite varied by sector and business activity. Managers are not specifically trying to capture the next target but are aware a sensibly constructed portfolio of stocks should receive their fair share. This is a dynamic which could persist for some time during the early stages of recovery.
Jon Rebak is manager of the HSBC open global return and HSBC open global distribution funds