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Stocks are more in sync, less connected to fundamentals

Traders work on the floor of the New York Stock Exchange on January 13, 2016, in New York City.
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Traders work on the floor of the New York Stock Exchange on January 13, 2016, in New York City.

As earnings season begins, indications show stocks are getting more disconnected from corporate fundamentals — the latest sign of just how much the search for returns may be distorting markets.

The U.S. Federal Reserve's low interest rate policy and moderate global growth have kept Treasury yields near all-time lows. As a result, investors have preferred to buy stocks, pushing the S&P 500 to record highs with sectors moving in tighter correlation to one another, or more similarly, than they have in the recent past.

The average correlation between any given S&P 500 sector and the broader index rose to 84 percent last month, according to a Convergex report published Tuesday. That level tops the sub-70 percent correlation figures of the second quarter of this year, and approaches the 97 percent correlation of 2011, the note said.

"If you historically can outperform by picking the right sectors, this (correlation) tells you, you have to be more dramatically underweight or overweight," said Nicholas Colas, chief market strategist at Convergex.

Correlations among sectors usually rise when the market is influenced by major external events, versus actual earnings growth.

The S&P 500 is expected to post its fifth-straight quarter of declining earnings, according to Reuters. Stocks themselves are expensive, and persistent lack of earnings growth raises concerns that stocks won't be able to rise much further.

"The average stock is trading near tech bubble levels," Bank of America Merrill Lynch's Head of U.S. Equity and Quantitative Strategy Savita Subramanian and her team said in a Tuesday note. The projected price-to-earnings ratio for the S&P 500 over the next 12 months was 16.7 in September, 10 percent above the historical average, according to BofAML.

Median price-to-earnings ratio nearing tech bubble levels

S&P 500 median forward P/E, 1986-9/30/2016

Source: BofA Merrill Lynch US Equity and US Quant Strategy

But despite the historically high average, "relative to other asset classes, the case for stocks is most compelling versus bonds, where the risk premium remains elevated and the S&P 500 dividend yield trades near a 60-year high versus the 10-year Treasury yield," the note said.

The S&P 500 climbed to all-time highs this summer and has remained within 4 percent of those levels. Over the last 12 months, defensive, high-yielding sectors such as telecommunications and utilities have been among the top performing sectors.

High valuations and high correlations "stem from the same basic uncertainty for stocks because we're in these uncharted waters," Colas said. Investors "don't know what is the right valuation for stocks."

In this environment, investors may need to explore other strategies such as selecting stocks across industry sectors based on factors of market cap size or volatility.

"We do think we're at an important point in the industry. It's not so much about stock picking but understanding your sources of return," Jennifer Bender, director of research for global equity beta solutions at State Street Global Advisors, told CNBC in an interview at the end of September.

That said, some analysts expect S&P 500 earnings per share to return to growth as soon as the third quarter. If that happens, then sector correlations should decline with improving fundamentals. The Federal Reserve is also expected to raise rates in December, taking another step away from very easy monetary policy that has kept interest rates low and stocks elevated.

"Recently we've seen, as interest rates have risen (there's been) more focus on fundamentals," said Brad Neuman, vice president and client investment strategist at Fred Alger Management. He expects the bond-like utilities and consumer staples sectors to give back much of their gains and sectors like consumer discretionary, health care and technology to perform better.

Technology stocks bounced back this summer as most beat earnings expectations.

Correction: This article has been updated to reflect that Neuman is client investment strategist at Fred Alger Management.