Since the US election day and surprise victory of Republican president-elect Donald Trump, US companies have been riding on the wave of high investment confidence which has boosted their stock prices substantially. In just two months, there has already been over $70 billion inflow of investments.
Yet, over the same period, correlation between stocks has plummeted and stocks are fluctuating independently, resulting in what speculators call the “market of stocks”. They believe that this indicates a good year for mutual fund investors and stocks picking, and even conclude that the market would continue to be bullish with no large declines.
Well, is this really true? We would find out in this issue.
Year of Tumbling Correlation Breeds Well for Stockpickers?
Source: Call Levels
CBOE tracks the relationship between stocks in the S&P 500 Index. While the index has gained almost 6% in just 2 months, the Implied Correlation Index has tumbled from 61 on the day of elections to below 50.
This means that instead of moving in tandem with the entire stock market and general investors’ sentiment, individual stocks are fluctuating independently based on their own company performance and fundamentals.
Inherent Theoretical Flaws
However, Mark Hulbert, a senior investment columnist, identified the serious inherent flaws in using correlation as a basis for inference.
Firstly, market volatility is a confounder factor. When the market becomes less volatile, the correlation between stocks and the market would naturally decrease.
In this case, there could be no changes to the actual performances and relationships between companies but this reduced market volatility decreases the correlation and gives the false impression that companies are less affected by one another.
Coincidentally or not, when the Correlation Index fell since 8 November 2016, the Volatility Index also dropped by almost 50% in the same period.
Secondly, the effectiveness of using correlation as a basis depends on the state of the market. Correlation tends to be higher when the market is at its bottom because of typical investor psychology. During bad times when investors are more paranoid, any small event could spark off a selloff.
When an investor sells, other investors tend to adopt the herd mentality, following suit before analysing the rationale, so that they can minimise their losses. While this has no economic basis, it can unnecessarily boost the correlation and effectively bring down the stock market.
As a result, Mark Hulbert cautioned investors who assume that there would be no sharp decrease in the stock market just because of the low correlation index.
In fact, as the 2008 Global Financial Crisis unfolded, the correlation index was lower than today’s. Did the correlation index then forewarn investors of the financial catastrophe?
Based on just correlation, we cannot merely assume that stock picking is the way to go.
Vulnerable to Reversal and Simultaneous Decline
Source: Call Levels
Ever since the elections, investments have been pouring into US equities while large outflows that amounted to $10 billion occurred in the emerging market equities and bonds market.
However, analysts warn of an imminent reversal and a unison decline in the US stocks market. Yes, a unison decline that spreads across the entire market and affects all the listed stocks, despite what the correlation index implies.
With the sheer amount of money invested into US equities, traders could potentially identify a peak price to sell them off for a massive profit. This places the US stock market at jeopardy as compared to other asset classes such as gold and bonds that tend to have “less vulnerability to profit-taking.”
This sentiment is shared by major banks including Bank of America, Morgan Stanley and Goldman Sachs which have forecasted that the US equities market would not do well in the second half of the year.
Analysts assert that this is largely attributed to the uncertainty created in the economy by Trump and his economic policies. While it is true the deregulation, corporate tax cuts, tax holidays and massive government spendings would create an environment for the local economy to thrive, the inflationary pressure and appreciation of the free floating US currency would be inevitable as well.
This means that US exports would lose their price competitiveness and leave the Federal Reserve with little options besides increasing the interest rates again and again, as acutely pointed out by Morgan Stanley analysts.
Former Chief Economic Adviser and Treasury Secretary under the previous 2 presidents, Lawrence Summers, publicly criticised his policies and even warned that Trump is “setting the stage for the next financial crisis.”
“Stretched” Equity Rally
Source: Call Levels
Deutsche Bank analysts further elaborated that the US equities market are “stretched”. US stocks have been performing well but would be unlikely to continue the streak this year especially with Trump’s questionable economic policies and aggressive foreign policies.
The Global Macro Surprise Index is also at its high. It tracks the frequency of market data being aligned with forecasts and a high on the index indicates a large deviation from expected growth and huge fluctuation in the markets. This certainly does not bode well for investors.
Where should I put my money in then?
Goldman Sachs analysts recommend investors to change their focus from US S&P 500 to the emerging markets, excluding China.
As elaborated in the previous issue, emerging markets including Brazil, Russia, India, South Africa as well as several Asian markets are more suitable investment options because of their internal stability and lower dependence on the current erratic US. Index funds investors might want to consider these countries in their investment strategies.
As for mutual funds investors who are still more convinced by the correlation index, they could perhaps select companies on the “basis of stellar long-term performance” and strong fundamentals.
Stock market or market of stocks? Your call.
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(By Call Levels)