Stocktake: Nervy stocks rise/fall

Nervy stocks rise/fall One clear sign of market nerves is when correlations spike, with stocks rising and falling in unison.

That’s certainly the case at the moment. Correlations among S&P 500 stocks almost doubled over the last month, hitting their highest levels since 2011’s European debt crisis. Additionally, the 20-day correlation between US stocks and the MSCI World Index recently soared to 0.82 (the maximum reading is 1.0, meaning that the indices are perfectly correlated), even higher than that seen during the 2008-09 financial crisis.

Correlations have also risen in Europe and Asia, although not to the same extent as that seen in the United States.

Correlations always spike in times of perceived crisis. That can be frustrating for diversified investors, who might have assumed that some of their holdings would hold up better than others, thereby cushioning their portfolio in times of trouble. But savvy bargain hunters should root for correlation spikes. They are evidence of indiscriminate selling, of a market herd mentality. They're ideal times for picking up cheap stocks. ETFs threat to active funds No doubt, active fund managers will say the correlation spike has dented their ability to outperform. It's hard to prove your stock-picking skills, the argument goes, when every stock is moving in unison.

In truth, their performance was lousy even before the recent herding action. The latest S&P Dow Jones Indices scorecard shows 65 per cent of large-cap managers underperformed over the last year. A majority of active funds underperformed in nine of 13 asset classes tracked over the last year; over 10 years, a majority underperformed in all 13 classes.

Little wonder active investors are flocking to so-called "smart-beta" exchange-traded funds (ETFs). Last week Goldman Sachs announced it was entering the space, creating indices that weigh stocks according to value, momentum, high quality and low volatility.

ETFs based on fundamentals attract active investors because they are cheap, systematic and transparent. In contrast, many conventional active funds are closet trackers. Others are headed by skilled managers, but it’s extremely difficult to identify such funds in advance.

Even if you do identify a top fund, what if their best analysts jump ship? What if, asks Irrelevant Investor blogger Michael Batnick, the fund manager gets divorced or wants to spend more time with his kids?

Fundamental indexing, Moody’s said recently, is “the next battleground for asset management dollars”. Goldman’s entry into the field shows the battle is well and truly under way.

US facing revenue recession US earnings season is nearing, and investors aren't optimistic.

Earnings are expected to decline 4.4 per cent, according to FactSet, whilst revenues are forecast to suffer their third consecutive quarterly decline, marking the first so-called revenue recession since the 2008-09 financial crisis.

That sounds grim but bulls note the figures are distorted by the 65 per cent collapse in energy sector earnings. Excluding energy, overall earnings are expected to register a small gain. Additionally, most firms habitually beat lowballed estimates. Besides, markets are forward-looking: a lacklustre earnings season may already be priced in.

Still, there's no room for complacency on that score, given stocks suffered a heavy sell-off after manufacturing giant Caterpillar announced job cuts and lowered guidance last Thursday.

Investors have been in a glass-half-empty mood for some time now, so the last thing they’ll want to see is a further deterioration in corporate fundamentals.

Leverage and the 'timebomb' Some arguments, no matter how bad, just never die.

Readers of the ever-apocalyptic Zero Hedge blog were recently cautioned to beware the "margin debt timebomb". As markets peaked in June, margin debt – money borrowed to buy stocks – hit all-time highs. The worry, apparently, is that leverage fuelled market gains on the way up; now, forced selling on the way down could turn the correction into a crash. Well, no. As we've noted before, some investors will always buy stock on margin; if stocks rise, so must margin debt. Yes, sudden spikes in margin debt can indicate excess. Chinese investors went gaga for margin prior to the recent crash. US investors also levered up prior to market tops in 2000 and 2007.

However, there has been no sign of this excess since the US bull market began in 2009; margin debt as a percentage of stock market capitalisation has been largely unchanged.

Markets may have topped – who knows? – but investors should ignore this guff about a leveraged timebomb.