Historically, Individual stock correlations with the index usually rise when the market falls as investors sell out of stocks and sectors, however there may be more pervasive reasons why correlations could go up in future years.
ETFs and Correlation
ETF growth could be a cause, as ETFs are taking an increasing share of stock and bond market investment. ETFs tend to be passively managed. They buy and sell stocks and bonds, in order to mirror market cap weightings rather than their underlying fundamentals. Similarly, sector ETFs tend to follow the same approach. All of which, should create an environment whereby individual stocks and sectors tend to move in step with each other. Furthermore, it will make achieving stock diversification a lot harder.
The Effects of Globalisation on Markets
As the global economy and its markets become ever more integrated, the fundamentals that drive prices will become increasingly integrated. The business cycle will become more synchronised as will policy decisions by ruling parties. The resulting lack of diversification may cause superposition within the global economy and- given the implied directionality-may increase the risk of meltdown, when it all goes wrong. Indeed, Taleb (2007/2010) in "The Black Swan: The Impact of the Highly Improbable" develops a similar line of argument.
Indeed, each successive recession seems to have got deeper in magnitude and required lower and lower interest rates in order to stimulate the economy. Therefore, a potential increase in correlations could be seen as, merely reflecting the underlying reality of how the global economy is changing.
The Role of Leverage and how Correlations Work Historically
Alternatively, increasing correlation could be a merely an extenuation of previous market conditions. Historically, as markets fall, the only thing that has risen is correlations, liquidity problems and panic, cause investors to indiscriminately sell out of investments. As leverage becomes an increasing part of global trading, this attribute of market trading could be accentuated. In this scenario, Delta trading or stock market timing, becomes the only game in town, as correlations go up in the fall and stay high, even given a bounce.
If this argument is correct than low correlations can be seen to be contingent upon relatively stable market conditions. So, investors should integrate these changing market conditions into their strategies, provided correlation levels are a factor in their performance. Market conditions cannot be relied upon to stay stable.
Correlations Affect Investment Strategy
With increasing correlation, alpha generation becomes a pointless exercise as individual assets move together in line with an index. For equities, stock picking and fundamental research is a waste of time. Investment is reduced to delta trading, or in other words, being in and out of markets and assets classes at the right time.
Furthermore, certain hedged strategies are affected. Equity market neutral strategies are affected if they are making assumptions as to their underlying beta exposure. Stock beta will move around unusually. For example, in a falling market long stock/short index strategies may find them under exposed on the short side as correlation suddenly jumps. Similarly, long stock/short sector will be exposed to the same sort of risks.
In this scenario, the correct thing to do would be to run an equal weighted correlated stock portfolio alongside a short position in the index. The trouble is that doing this will tend to reduce the opportunities for significant alpha generation as any semblance of stock/sector preference is ironed out by market weighting.
Tactical Asset Allocation Strategies
Tactical asset allocation strategies seek to eliminate the attempt to generate alpha in favour of trading asset classes against each other. However, even these strategies won’t work in this scenario because increasing correlation within asset classes will create difficulties. So what to do if increasing correlation is a persistent part of the investment world?
Statistical Arbitrage Strategies
Statistical arbitrage or stat arb, strategies tend to use mean reversion techniques in order to isolate unusual trading positions. They rely on statistical signals that provide entry and exit levels into trades. If correlation is on the increase, then the signals given for, say two dislocated stock market sectors will be more relevant, because the signal is seen as reflecting greater statistical outliers. Therefore, these outliers or price dislocations could be closed easily as markets trend towards correlation.
Stock Market Investment Strategies
Another strategy that could work is to find sectors that are characterised by high degrees of uncertainty and the opportunity for significant volatility on their earnings prospects. For example, as the whole sector gets sold off indiscriminately, the stock price of individual companies-who might have with significant upside to their earnings - will be sold off. If the significant upside event occurs, then these stocks will outperform.
Two sectors that exhibit these characteristics are biotech (where clinical trial results will guide prospects) and Oil exploration (well results) and the prospect for alpha generation with a long stock/short sector approach may, in fact, be raised by increasing correlation.
Taleb, Nassim Nicholas (2007/2010). The Black Swan: The Impact of the Highly Improbable.