“Yet another reason equities will fall…”

Citi touts the latest metric to justify an equity pullback

Everyone has their favourite metric for measuring equity market valuations (and calling the beginning/end of the bull/bear market on CNBC).

Best known is Shiller’s Cyclically Adjusted Price/Earnings (CAPE). Buffett’s prefers to compare a country’s market capitalisation to its GDP.

Citi’s latest analysis (chart below) cites falling correlations as a reason why the S&P 500 is due a dip.

Their argument, in short:

  • Falling correlations between equities in the index suggests that portfolio managers are increasingly confident in owning individual stocks (err… isn’t this what active investing is all about?)
  • This ‘micro’ focus on individual stocks implies ‘macro’ complacency, or investors’ relative comfort with macroeconomic conditions.
  • This is worrying — in the past, low correlations have preceded equity market weakness

But how strong is this correlation, and is it reason enough to sell? A cursory glance at the chart suggests that it is not. Since the financial crisis, the S&P 500 has moved in one direction, while correlations have oscillated like a seismograph.

Source: Citi Research, 22 June 2017

And there are benefits to falling correlations.

For a start, if lower correlations suggest that portfolio managers are focusing more on stock selection, then all the better. It’s generally easier to understand a company than it is to forecast macroeconomic events. And indeed, the former is what money managers are paid to do.

Lower correlations also address (legitimate) concerns that the wave of passive investing is going to increase correlations to worrying levels.

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