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Something very good is going on under the market’s surface

The correlations among S&P 500 sectors have fallen to the lowest level since the financial crisis. And while correlations may sound obscure, the development is actually great news for almost all investors.

Over the past 60 sessions, the average correlation between the daily moves of two S&P 500 sectors is about 0.47, and was as low as 0.45 in the 60 sessions ending Thursday. That is substantially lower than the figure's median reading of 0.69 over the past five years, and is a dramatic drop from the 0.83 seen just in October.


Both active and passive investors should cheer this quiet market trend.

For the active, who believe they can add value by overweighting some sectors and underweighting others, such decisions begin to make more sense. A portfolio that holds many consumer discretionary stocks and few utilities stocks, for instance, has a better chance of performing dramatically differently than the S&P 500 in a low-correlation environment.

There's a benefit for passive investors, too. As correlations fall, the benefit of diversification rises, since higher correlations translate into a lower degree of volatility without necessarily reducing the expected gain.

Translation: In a low-correlation world, there's a smaller risk that every stock one holds falls together. Of course, there's also a smaller chance that every stock rises together, but since most investors dislike losses more than they like gains, a decreased chance of the volatility that carries the portfolio higher is a worthwhile trade-off for a decreased chance of the more painful sort.

"Five years ago the stock market went up together and everything went up together, or it went down together and everything went down together. And that was really unhealthy because it meant there was no value in diversification," Convergex chief market strategist Nicholas Colas said Monday on CNBC's "Trading Nation." He said this happily appears to no longer be the case.

The so-called risk-on/risk-off dynamic appears to have broken apart, with a few distinct forces now moving stocks. According to Colas, prime among these are the reach for yield amid falling bond rates, the commodity comeback, and new-found weakness in the U.S. dollar.

If one correctly chooses which of these forces to ride and which to fade, one should expect to outperform the overall market by a substantial margin, given the correlation decline.

Whether the wisdom this would require is attainable, however, remains another story.

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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Brian Sullivan

Brian Sullivan is co-anchor of CNBC's "Power Lunch" (M-F,1PM-3PM ET), one of the network's longest running programs, as well as the host of the daily investing program "Trading Nation." He is also a frequent guest on MSNBC's "Morning Joe" and other NBC properties.

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