This article was originally posted on Forbes.
The last three years have been dismal for fundamental long/short managers, and stock picking at large. However, at Sentieo, our analysis shows that we are currently in the best environment since before the 2008 crash for picking stocks. Now, that isn’t to say that this is the best time to buy stocks, nor is it a prediction of fund performance. But, according to an analysis of one metric, cross-correlation, the current market should provide an unusually ripe environment for stock picking.
First, a bit about what we mean by cross-correlation: The pairwise correlation between two stocks is a value between -1 and 1, that indicates how likely the two securities are to move in the same direction. Over a given time period, two stocks that perform identically will have a value of 1, two stocks have no correlation at all will have a value of 0, and two stocks that are perfectly inversely related will have a value of -1.
We ran the pairwise correlations between every stock in the S&P 500 and every other stock in the index (249,500 computations!) from the 2007-8 financial crisis until now. Averaging all of the correlations provides an indicator of how much stocks move in tandem with each other. If the cross-correlation is 1, there would be no opportunities for stock picking since all stocks would move in tandem with each other. The higher the value of the index, the more difficult it is to make money by selecting individual securities at that point in time.
The graph below shows the cross-correlation for the entire S&P 500 over the past decade. There are a few important takeaways from this chart. First, it is clear that the cross correlations of the S&P 500 are at decade lows. Second, we see a preponderance of large spikes in the data.
As you can see, the spikes correspond with market shocks, the major macro events of the last decade. The jump in cross-correlation following a market shock is to be expected. When this sort of event happens, the entire market tends to turn in one direction as it collectively decides to buy or sell. The most recent inflection point, however, the 2016 election of Donald Trump in the United States, behaves differently.
The 2016 US Presidential election has driven correlations to new lows. Furthermore, correlations in the market actually began dropping prior to the November 8th election day, around the time when then-FBI Director James Comey sent a letter to Congress on October 28th. As opposed to the market shocks where the market all reacts in the same direction, it seems the collective market doesn’t know how to react to Donald Trump with any certainty. In other words, as of today, Donald Trump is an inherently uncertain entity that is creating opportunities for security selection.
Impact on Hedge-Fund Returns
As shown in the chart below, hedge fund monthly returns for long/short equity managers tend to react inversely to cross-correlation, as we would expect. This provides further validation to the idea that cross-correlation is a solid predictor of the overall environment for stock picking.
We can further apply cross-correlation to show the volatility of selected sub-sectors of the S&P 500. Doing so, we can demonstrate which specific sectors may have benefitted the most from the US election, again, purely from a stock-picking perspective.
The Financial Sector
The financial sector, understandably, showed the largest drop in correlation after the Comey letter. (In the graph below, the letter’s release corresponds directly with the drop preceding the 2016 election). The sector overall, however, remains relatively highly correlated. This is to be expected from a heavily regulated industry, with regulation having a dampening effect on volatility. The five largest stocks in this sector are the following; JPM, WFC, BAC, HSBC and C.
The Technology Sector
Technology looks fairly similar to financials in that we see a precipitous drop following the Comey letter, with a small bounce back in recent months. The group, however, runs at a lower average correlation in general than does the Financial sector. Tech correlations have crept up recently because some investors and brokerage houses have begun voicing concerns about valuations in the past few weeks. The five largest stocks in this sector are; AAPL, GOOGL, GOOG, MSFT and FB.
The Consumer Services Sector
The Consumer Services sector has shown a modest decline in correlation since the election, but with no bounce back in recent months. Furthermore, it has the lowest cross correlation among all the sectors listed, at less than 0.2. The largest five components of this sector are AMZN, WMT, HD, CMCSA and DIS.
The Energy Sector
The Energy sector has not seen the same large drop in correlation resulting from the election. It has shown some mixed results of late, perhaps in part due to the recent selloff in oil prices. The five largest stocks in this sector are; XOM, GE, CVX, TOT and PTR.
The Capital Goods Sector
The Capital Goods sector has dropped to its lowest point in the decade by far; a more drastic reaction than all of the previous sectors discussed. This is perhaps due to the prospect of increased infrastructure spend which has been proposed not only by the White House, but also by members of the Democratic party. The five largest stocks in this sector include; TM, BA, HON, UTX and LMT.
While not making a call on the direction of stock prices, we have found that the current environment is the best for stock picking in a decade and that this is, in some capacity, due to the uncertainty emanating from the Trump Administration. We have found this effect to be particularly pronounced in the Capital Goods and Consumer Services sectors.
Therefore, active long/short fundamental equity managers should be looking for stock picking and pair-trading opportunities right now.