Dear Member,

Stock price movements have become highly correlated, with correlations reaching levels not seen since 2008. This is not surprising given historical data and should end up being a temporary occurrence.

Correlation, in financial terms, is a mathematical model that indicates how closely the returns of various assets match each other. Correlations can range from +1.0 (assets have returns that move in lockstep together) to -1.0, (assets have mirror opposite returns). Correlations may be expressed in decimal format (e.g., 0.72) or percentage format (72%).

Over the long-term different types of stocks have varying correlations. Small-cap stocks, for instance, have a long-term correlation of 0.72 with large-cap stocks, according to the Ibbotson SBBI 2011 Classic Yearbook. This means that while small-cap stocks have similar returns to their bigger brethren, they do not always move in the same direction or experience the same magnitude of change. Thus, you get some diversification benefits by combining small- and large-cap stocks in a portfolio. (Mixing in micro-cap, developed foreign market and emerging market stocks into a portfolio provides even more diversification benefits.)

Even among large-cap stocks, long-term correlations stay below +1.0 due to differences in industries, business conditions and valuations. For example, the performance of Bank of America (BAC) is affected by factors that don’t directly influence Apple (AAPL) or Exxon Mobil (XOM). Thus, under calmer market conditions, diversification benefits can be realized even among large-cap stocks.

During periods of market duress and volatility, correlations move toward 1.0. This is what is happening right now. Nicholas Colas, the chief market strategist for the ConvergEx Group, calculated that “average correlations between the 10 major sectors of the S&P 500 have reached 97.2%” for the 30-day period ended September 9, 2011. This is the highest correlation since 2008’s financial crisis. Coincidently, Vanguard just issued a research note showing last month’s volatility in the S&P 500 as being the highest since the second half of 2008. Volatility brings higher correlations.

The big reason for the volatility and consequent high correlations are macro factors. Headlines about the U.S. economy, the lack of bipartisanship in Washington, and European sovereign debt problems have shifted the focus of institutional investors to the big picture, and away from individual company stories. (As today’s drop in shares of Netflix (NFLX) showed, individual company stories aren’t being completely ignored, however.)

Rising correlations diminish the benefits of diversification and the potential excess return that can be realized by picking individual stocks. Correlations are not static numbers, however, and periods of higher correlations have historically been followed by periods of lower correlations. Therefore, it would be a mistake to assume that diversification has stopped providing benefits. More importantly, when the returns of stocks move in lockstep and ignore the fact that individual companies’ industry classifications, business models, financial status and valuations are different, many stocks become mispriced. And when stocks become mispriced, opportunities for astute stock-picking present themselves.

Are you looking for opportunities among individual stocks or relying more on index funds? Tell us on the AAII.com discussion boards.

International Correlations Should Fall Too

International stocks are also displaying high correlations with U.S. large-cap stocks. Colas calculated the MSCI EAFE (Europe, Australia and the Far East) index as having a 96.2% one-month correlation with the S&P 500. Emerging market stocks had a 97.4% correlation.

Just as with U.S. domestic stocks, global stocks become more correlated during periods of market turbulence. These high correlations fall after the crisis passes, resuming the benefits of diversifying globally. Bernard Horn of Polaris Capital Management discussed the historical record of international correlations in the December 2010 AAII Journal.

Model Portfolios Updated on AAII.com

The market continued its recent downward movement in August as investors showed their disdain of government partisanship in the face of continued high unemployment and a stalling economy. The S&P 500 lost 5.4%, while smaller caps fared even worse. Growth stocks, on average, performed slightly better than value stocks.

The Model Shadow Stock Portfolio lost 11.0% for the month; ironically, this was its worst month since August 2010. The Vanguard Small Cap fund (NAESX) lost 8.3% and the DFA US Micro Cap fund (DFSCX) lost 8.9%. For the year, the Shadow Stock Portfolio is now down 5.1%, the Vanguard Small Cap fund is down 5.0% and the DFA US Micro Cap fund is down 6.5%.

There was one transaction in the Shadow Stock portfolio. AeroCentury (ACY) was sold due to negative earnings. The proceeds were used to buy Hooker Furniture (HOFT).

The Model Mutual Fund Portfolio was down 5.8% for the month, compared to the Vanguard Total Stock Market fund (VTMSX), which fell 6.0%. The Model ETF Portfolio declined 7.4%, whereas the 80% SPDR S&P 500 ETF (SPY) and 20% iShares MSCI EAFE Index ETF (EFA) benchmark lost 6.2%. Year to date (through August 31), the Model Mutual Fund Portfolio is down 4.6%, while the Vanguard Total Stock Market fund is down 2.3%; the Model ETF Portfolio is down 5.6%, while its benchmark is down 2.7%.

See the model portfolios.

The Week Ahead

We will get an early look at third-quarter profits with some of the traditional early reporters within the S&P 500 announcing their results. Those companies are Adobe Systems (ADBE), AutoZone (AZO) and ConAgra Foods (CAG), which report on Tuesday; Bed Bath & Beyond (BBBY) and General Mills (GIS), which report on Wednesday; and CarMax (KMX), FedEx (FDX) and Nike (NKE), which report on Thursday.

The Federal Open Market Committee will hold a two-day meeting, starting on Tuesday. The committee’s statement, which will be issued on Wednesday afternoon, will be scrutinized closely. Specifically, economists and traders will be looking to see if the Fed announces a new form of stimulus, such as buying long-term Treasury bonds. The committee was divided during the August meeting on whether additional actions were needed by the Federal Reserve to spur economic growth, and it is uncertain whether anything will be announced following this meeting.

Beyond the Fed meeting, there is not much on the economic calendar. The National Association of Home Builders will release its September housing market index on Monday. Tuesday will feature August housing starts and building permits. August existing home sales will be published on Wednesday.

The Treasury Department will auction $11 billion of 10-year inflation-protected bonds (TIPS) on Thursday.

No Federal Reserve officials are currently scheduled to speak publicly.

AAII Sentiment Survey

Bullish sentiment increased 0.3 percentage points to 30.5% in the latest AAII Sentiment Survey. The slight change kept optimism that stock prices will rise over the next six months below its historical average of 39% for the eighth consecutive week. This was also the 19th time in 22 weeks that bullish sentiment has been below average.

Neutral sentiment, expectations that stock prices will be essentially unchanged over the next six months, fell 1.3 percentage points to 28.2%. This is the ninth consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.1 percentage points to 41.3%. This was the fifth time in the past nine weeks that bearish sentiment has been above 40%. It is also the 27th time out of the last 30 weeks that bearish sentiment has been above its historical average of 30%.

The numbers show continued pessimism on the part of individual investors. Bearish sentiment is back to being more than one standard deviation above average, making it unusually high, but not extraordinarily so. Bullish sentiment, though below average, is not yet at levels that would make it usually low, however.

The pessimism is a continued reaction to the negative headlines. Individual investors are concerned about the volatility in stock prices, the slow pace of economic growth, sovereign debt concerns (both in the U.S. and in Europe) and Washington politics.

This week’s special question asked AAII members about their longer-term outlook for stocks. Specifically, we asked whether stocks had more potential upside or downside over the next 12 to 24 months. The majority of respondents thought stocks had more potential upside, though a sizeable minority anticipated more downside. Many predicted continued volatility, even those who anticipated stocks to show gains or losses.

Several members pointed to next year’s presidential election as a potential catalyst. (How the election results will affect stocks depended on the member’s political bias.) Other members cited the level of fear about the U.S. economy, overseas profit growth and sovereign debt problems (including U.S. debt) as factors affecting their outlook.

When we asked the same question last April, the responses were divided, with slightly more AAII members anticipating a further rise in stock prices over the next 12 to 24 months than those who thought stock prices will fall.

Here is a sampling of the responses to this week’s special question.

• “I don’t think the world is going to end, so I expect more upside than downside despite mediocre to little growth in developed markets.”
• “It does seem that, longer term, stocks are cheap. If another full-blown recession can be avoided, stocks should be higher in the long term.”
• “I expect generally more upside, but there are so many events that will steer the market sharply down.”
• “More volatility ahead. I anticipate spurts, both up and down.”
• “More downside. European and U.S. debt problems combined with the inability to tackle financial commitments will weigh economic opportunity down.”
• “The longer-term prognosis will depend on the 2012 election.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor

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