Christopher Caparelli, CFA
So far, 2014 has seen a number of things fall: unemployment, interest rates, the pace of QE3, and correlations among U.S. equities. It is conventional wisdom that in times of crisis, correlations move to one and all equities fall in unison. Since 2008 when the correlations between sectors in the S&P 500 did indeed approach one, active equity managers have bemoaned the lack of dispersion that is commonly present in the U.S. equity market. When dispersion is low and correlations are high, it is difficult for active managers to outperform a benchmark. During periods of high correlation, the market reacts to macro-type factors, punishing or rewarding all equities at once with little regard to stock specific fundamentals.
In 2014 however, correlations have once again begun to exhibit a downward trend, allowing active managers more opportunities to separate themselves from a benchmark. As measured by rolling 21-trading day windows, average correlations between the 10 sectors of the S&P 500 and the index itself reached a low of 63% in May, a level not seen since late 2010. If the trend of lower correlations continues throughout the year, expect greater dispersion between individual equities to be closely followed by greater dispersion between active managers and their benchmarks.
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