Whenever somebody asks a question like: “Is stock picking a dead art?” The contrarian in all of us looks for the other side of the trade. The past week or so has brought a raft of articles about rising equity correlations. What we are seeing is an unprecedented level of co-movement between individual stocks and sectors. Fear is certainly part of the equation. There have also been some structural changes in the stock market. The bigger question is what to make of it all?
First off it should be noted that these correlations tend to mean-revert. High correlations eventually give way to lower correlations as market conditions return to normal. The point that many analysts are focusing on is whether the average level of correlations have increased over time. Many reasons are given for this possibility including the rise of ETFs and other structured products.
The true contrarian would look at this and see a potential opportunity. If everyone else is playing the risk on/risk off, sector rotation game then maybe it is time to play a different game. Unfortunately that different game requires a very different time horizon. Individual traders have already abandoned very short term trading as that is now dominated by automated trading. This therefore leaves only the long run as a potential area of advantage.
The correlation game really only matters to investors with the time horizon of the next reporting period. For investors with a truly long term time horizon some individual stocks have been left by the wayside in this market. Taking advantage of these opportunities requires riding out market waves that have little to do with a stock’s true worth.
The vast majority of institutional investors will find it difficult to take on these opportunities. Luckily, individual investors with a longer term time horizon can look for specific opportunities. Bloggers like Felix Salmon will say that individual investors have no business picking individual stocks. They are likely correct that most individual investors have neither the experience, interest or wherewithal to purchase individual stocks. That is in part why the ETF sector business is so robust.
For some time now people like Mark Cuban have been bemoaning how the stock market has lost its mission as a vehicle for capital formation and has simply become a virtual casino. Picking and holding stocks with a long term horizon is this antithesis to this sort of behavior. Don’t hold your breath waiting for the return of the long term investor. Everything in the financial markets (and media) is set up to encourage short term thinking and trading.
This correlation wave will crest at some point. Individual stock and sector correlations will ebb. Whether they get back to historical remains remains to be seen. At some point opportunities will have been revealed. However don’t think that these opportunities are either obvious or easy to exploit. If they were, they wouldn’t be there in the first place.
For some additional reading on the topic of stock correlations see:
Is stock picking a dead art? (WSJ)
Are ETFs ruining the stock market? (The Reformed Broker)
Fear is driving stock correlations higher. (Huffington Post)
There is nothing new about this trend. (Fund My Mutual Fund)
Some interactive correlation charts. (Don Fishback)
[Earlier] The forthcoming golden age of stock picking. (Abnormal Returns)
[Update] There is still money to be made in stock picking. (Dealbreaker)