One of the primary investing trends in the post-crisis market is breaking down, providing an opportunity—at last—for stock picking to come back into vogue.
Correlation, or the tendency of asset classes to move up and down in unison, is at a more than five-year low, according to data from New York brokerage ConvergEx. High correlations have been a characteristic of the market ever since the Federal Reserve started its historically active intervention in the financial markets, in large part through a bond-buying program that swelled the central bank's balance sheet past the $4.5 trillion mark.
The program, known as quantitative easing, helped tamp down volatility and in turn led to what market participants call the "risk-on risk-off" trade, in which most stocks moved in the same direction depending on the mood of a particular day. Correlation approached almost perfect 100 percent levels at various junctures over the past few years and was at 85.4 percent as recently as November.
Now, that figure is at 58.4 percent, something that Nick Colas, chief market strategist at ConvergEx, believes marks just the beginning of a longer-term pattern.
"The end of the Federal Reserve's bond-buying program is allowing a wide range of asset types to perform more on their own fundamentals," Colas said in a note to clients. "We reiterate our observation that binary 'risk on, risk off' market moves are on the decline. Stock picking and sector allocations will be the most important investment challenge in 2015. And, hopefully, beyond."
"Hopefully" is a sentiment that will resonate with active managers, whose performance during high correlation periods has been abysmal. Barely 1 in 10 has outperformed basic market benchmarks like the and in 2014, with the difficulty in finding outperforming and underperforming stocks in a high-correlation world the primary culprit.
Clients have been fleeing active management, instead committing money to plain-vanilla index funds that, while not producing eye-popping returns, have been consistent winners during the bull market that began in March 2009.
Since 2006, investors have pulled $813 billion from actively managed mutual funds that focus on stocks while putting $960 billion into their passive counterparts in the exchange-traded fund industry, according to Bank of America Merrill Lynch. ETFs are just a whisker away from $2 trillion in assets under management—growing, but still just a fraction of the $15.7 trillion managed fund total, which includes $8.3 trillion in equity-based funds, according to the Investment Company Institute.
A change in correlations is unlikely to hinder the stampede of money into ETFs—including a 17.2 percent gain in 2014 alone, according to XTF.com. However, it might make some investors feel more comfortable about putting some of their idle cash into mutual funds.
Active managers, despite the chronic underperformance, themselves saw a 7.6 percent increase in funds over the past 12 months, including an 11.9 percent jump in equity funds.
"The worries that exchange-traded funds were driving correlations permanently higher now seem misplaced," Colas said. "Money flows into ETFs continue at a record pace, and correlations are falling."
If the declining correlation trend continues, it should mean better times for stock pickers.
"None of these points are especially easy to construct into a headline, to be sure," Colas said. "They are, however, important ones to consider for 2015."