Why Correlation Plunging Below 5-Year Average is Stock Pickers’ Dream

After trading in tandem for much of 2019, individual stock movements now are beginning to diverge sharply. Stock correlation, a measure of how individual stocks trade in relation to each other, has plunged to a six-month low and below the five-year average. That’s a sign that macroeconomic tensions are easing and stocks are being driven more by the idiosyncratic factors of individual companies, an ideal environment for stock pickers, according to a story in the Wall Street Journal as outlined below. 

“It becomes increasingly a stock picker’s market, where fundamentals matter more,” John Linehan, portfolio manager and chief investment officer (CIO) of equity at T. Rowe Price. 

What it Means for Investors

The average three-month rolling correlation for individual stocks fell to 0.23 at the end of last week, nearly half of the level of 0.42 at the end of October, according to data from Goldman Sachs, per the Journal. The current level is below the five-year average of 0.30 and the lowest since May 10, right before stocks experienced a sharp selloff on fears of an escalating trade war

Key Takeaways

  • Stock correlation plunges below 5-year average.
  • Correlations at lowest level since early May.
  • Macroeconomic tensions are beginning to subside.
  • Company fundamentals starting to matter more than macro factors.

Looking at individual stock sectors tells a similar story. The average three-month rolling correlation among the S&P 500’s 11 sectors fell to 0.56 from a level of 0.81 at the end of October. The sector correlation dipped below 0.50 in the first half of May before also climbing amid rising global trade tensions.

A correlation of 1.0 indicates that stocks are trading in perfect unison, where a correlation of 0.0 means there is no relationship between the movements of individual stocks. A correlation of -1.0 would mean stocks are moving by the same amount, but in opposite directions.

If stocks are trading together it’s generally a sign that investors are focused on broader macroeconomic factors. Escalating trade tensions and fears of recession are prime examples. But investor concerns are beginning to subside as the U.S. and China inch closer to a trade deal, the Federal Reserve signals a wait-and-see stance towards monetary policy, and economic data improves.

That’s good for active managers who are paid to outperform the market by betting on individual stocks. A study of large-cap funds by Barron’s revealed that a scant 22% of those that were actively managed outperformed the S&P 500’s annualized return of 13.35% over the past ten years through November 21. Most of those were growth funds. Just five large value funds out of a group of 241 beat the broad index. But with stock correlations falling, things could start to look up for the active stock pickers in the short term anyway. “We would expect good active managers with good skills to have somewhat of an easier time finding opportunities,” Sheedsa Ali, head of quantitative equities at PineBridge Investments, told the Journal.

Looking Ahead

Morgan Stanley is confident that the macro context will brighten and become less uncertain in 2020 as U.S. economic growth stabilizes and earnings begin to grow again. In a recent U.S. Equity Strategy report on the outlook for 2020, the bank indicated that there will still be uncertainty, but it will primarily reside at the level of individual company fundamentals, and non-U.S. equities look better than U.S. ones.

Article Sources
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  1. Wall Street Journal. "Stocks are Finally Diverging After Trading in Tandem," Accessed Nov. 26, 2019.

  2. Barron's. "The S&P 500 Has Trounced Active Funds for a Decade. Barron's Did the Math.," Accessed Nov. 26, 2019.

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