Correlations among stocks declined dramatically in 2012 from the record levels seen in the fall of 2011, implying a better stock picking environment for active managers. Still, correlations remain high from a historical perspective. High correlations indicate stress in the financial markets and imply that macroeconomic concerns are weighing on investors, overriding the individual characteristics of companies. When correlations are high, active managers may find it difficult to select securities, since the short-term performance of winners and losers can be indistinguishable.
Meanwhile, the risk-on, risk-off phenomenon returned in the second quarter. Large-cap equities were up sharply in the earlier part of the year, rising around 13%, following the LTRO and better global growth data. They fell nearly 10% as the European debt crisis worries resurfaced and economic data in China and the United States began disappointing market expectations. Market-friendly Greek elections and some signs of progress on bailout for Spanish banks steadied sentiment in June. Subsequently, equities rose steadily through Q3, approaching new highs, as sentiment improved dramatically following central bank action both in Europe and the United States.
* Average cross-sectional stock correlation is estimated as the average pair-wise rolling three-month daily stock returns’ correlations for all S&P 500 Index stocks’ combinations.