Since the end of October, there has been a sector rotation going on as investors have fled the sectors that led the way in the first ten months of the year and they have been moving assets to some of the sectors that lagged in the same period. The last few weeks have amplified the rotation and as a result we have seen a tremendous drop in sector correlation. Looking at other points in history when correlation has plunged, it has not been a good sign for the short-term outlook for the market.
From the beginning of the year through the end of October, the tech sector gained 31.7 percent, materials gained 20.3 percent, and healthcare gained 19 percent. During that same period the consumer staples sector only gained 4.7 percent, financials gained 15.7 percent and industrials gained 16.6 percent.
Since the beginning of November, the performance of these six sectors has completely reversed as the consumer staples have gained 6.6 percent, financials have gained 5.3 percent and industrials gained 4.4 percent. The biggest laggard over this time period has been the materials sector (0.7%) followed by the tech sector (1.03%) and healthcare (2.3%).
This rotation has caused the sector correlation to drop sharply in recent weeks. In fact, sector correlation is the second lowest it has been in the past 90 years, bested only by a period in early 2000. I think we all know what happened later in 2000.
What I noticed was that it doesn’t seem to be the plunge itself that we need to worry about, but rather the increase in correlation that happens after the plunge. I think the reason for that is this; as the correlation drops, investors rotate out of sectors that have been outperforming and in to sectors that are underperforming. This could be called “a rising tide lifts all boats” investment theory. However, when correlation starts rising after sharp plunges, the sectors move together once again, but it is because they are all moving down at the same time instead of all moving up at the same time.
SentimenTrader.com had some really good information on the correlation drops of the past and they looked at 10 time periods where sector correlation has dropped sharply since 1950. Their findings showed that the average one-month return for the S&P after these declines was -1.7 percent while the average three-month return was -1.0 percent. Historic averages for all such periods are +0.6 percent and +1.9 percent.
The numbers that were even more interest were the individual sector performances after correlation plunged. On the one-month returns, all ten of the main sectors showed negative returns with the financial sector performing the worst with an average decline of 3.9 percent. Telecom, healthcare and energy showed greater declines than the other sectors. The three-month returns for each sector showed one sector moving higher (consumer discretionary) and one sector breaking even (utilities). The other eight sectors showed negative returns for the three months following sharp declines in correlation. The financial sector was once again the worst performer followed by telecom, energy and staples.