S&P 500 Correlation Hits 6-Year Low

Here’s a tidy tidbit from the folks at Pavilion Global Markets:

Equities are finally done trading as a monolithic bloc. The average six-month correlation of weekly returns between S&P 500 constituents and the index itself has dropped to 0.41. This is the lowest average correlation since the beginning of 2007. This is also the biggest 12-month drop in average correlation over the past 22 years.

And here’s a chart to illustrate:

 

As the researchers note, the kind of drop we’ve seen isn’t common — before the recent decline there’d been only five instances since 1991 of correlation falling by more than 0.25. When it does happen, however, stocks have subsequently risen, on average by 2.1% in the following six months.

What�s interesting is that drops in correlation between stocks are also a buy signal for cyclical equities. As the table above shows, Industrials and IT usually lead the market in that environment. Defensive sectors such as Staples, Health Care and Utilities usually decline in the six months following correlation pullbacks. The Financial sector also declines 3.4% on average over the period. The exception would be Telecom stocks, which do well in this environment.

Of course, as noted above, such drops don’t happen very often so these average reactions are taken from a small sample size; nevertheless it’s an interesting trend to watch, and the evidence we do have suggests it’ll be good for the market.