'Hard to overstate' the importance of this new market development

Beneath all the enthusiasm for the gaudy numbers the stock market has been posting since the election is an earth-moving event that could have profound effects on the investing climate ahead.

It's all about what market pros call "correlation," or the tendency of individual stocks to move up and down together. Correlation has been one of the central features of the bull market that started in March 2009, with the market's components moving almost in perfect sync with each other during most of the rally.

That's made it a tough time for individual stock pickers, who use pricing disparities between individual companies as a way to beat the market. When everything is moving in line, those opportunities become much harder to find.

The result of the high correlations has been that only about 1 in 5 active fund managers has been outperforming basic market benchmarks like the S&P 500 or the Russell 1000. As a group, active managers are having their worst year ever, though it's improved lately.

Their fortunes could change even more, though, if current trends hold up.

Tourists take a picture with the market bull near the New York Stock Exchange (NYSE) on December 8, 2016 in New York City.
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Correlations for S&P 500 sectors were as high as 88 percent just a couple months ago but have slumped to 56.8 percent over the past month, the lowest reading since Nick Colas, chief market strategist at Convergex, began measuring in 2009. A 100 percent correlation would imply perfect movement between sectors.

"It is hard to overstate how important a development this is," Colas said in his Friday note to clients. "Lower correlations signal that investors are actively choosing winners and losers more aggressively than at any point since the financial crisis."

The main factor often cited for the high correlations rate was Fed policy — the U.S. central bank had been pumping the financial system with trillions in liquidity while keeping interest rates anchored at historically low levels. The result was a tamping down of volatility as financial conditions remained loose and the U.S. stock market was the best game in town.

Domestic stocks still look good, but other conditions have changed. The Fed has stopped printing money, and it's expected next week to resume what will be a slow path back to rate normalization with a quarter-point hike in its interest rate target.

But the biggest change of all is the election of Donald Trump, who has promised to pursue a track of lower regulation and taxes and higher spending, primarily on America's outdated and damaged infrastructure system.

"Now, we have a brand-new paradigm that is actually the same as the old [pre-crisis] paradigm," Colas said. "Since President-elect Donald Trump's surprise win, investors have been hustling to identify new macro trends [higher interest rates, primarily] and unlock potential winners [financials, industrials, materials and health care, for the most part].

"And since most investors don't have a lot of money on the sidelines, they are expressing these views by selling losers [tech and utilities] to buy the new market leadership."

That means a fertile ground for active stock picking, even as most investors flock to passive index investing.

To be sure, the move toward passive isn't going anywhere. Index-focused exchange-traded equity funds have taken in $164.3 billion in 2016, while their active counterparts in the mutual fund class have seen $273.2 billion in outflows through Wednesday, according to Bank of America Merrill Lynch.

However, the recent breakdown in correlations at least opens a window for stock pickers who have been on a fairly solid streak lately in terms of their performance against benchmarks. At least for more risk-tolerant investors, the Trump rally brings with it not just higher prices for the indexes but also a chance to gain alpha, our outperformance against the broader market.

"The 'Curse of Correlation' has lifted, for now," Colas wrote. "One month, however good, is not enough time to know for sure. But you have to start somewhere, even in the curse-breaking business."