One theme of our work this year has been the decline in sector correlations among the 11 industry groups in the S&P 500. This trend is, in many ways, more significant than the above-average +18% return for the index in 2017. Prior to January 2017, sector correlations were reliably +80%, month in and month out, all the way back to 2009. In 2017, they dropped to 50% and have stayed there.
To give you a sense of how unusual this drop in correlations has been, today we focus on just one group – Technology – and 2 time periods (1999 – 2004, and 2015 – present). There are two graphs below that show the data, but here is a brief description:
- During the late 1990s, Technology dominated the US equity market. As a result, the price correlation between the S&P 500 large cap Tech sector and the index as a whole was 85% to low-90%. (We use 90 day trailing correlations for all the math here. Email us if you want to see the spreadsheet).
- Then, quite literally on January 1st 2000, those correlations began to drop. They troughed at 69% in March, just as the dot com bubble started to roll over.
- The same move – from +90% correlations between Tech and the S&P 500 to less than 70% – occurred between November 9th 2016 and March 20, 2017. The difference, of course, is that US equity asset prices rallied over this time period.
What to make of this: it is important to understand just how dramatically US equity markets have changed this year. Correlations for one key group – Technology – have declined by the same amount as during the bursting of the dot com bubble. Except unlike in 2000, markets have remained in rally mode.
Moreover, we expect correlations to remain low in 2018 as deregulation and infrastructure spending take up the space that tax reform occupied on the Federal legislative docket. Since the breakdown in sector correlations so clearly coincides with the Republican Party wins in the 2016 elections, we believe that markets expect deregulation to be a dominant theme in the New Year.
Bottom line: correlations decline quickly only when investors rethink capital allocation in dramatic fashion. The decrease in sector correlations (Tech, in the case of our example here) this year rivals that during the bursting of the dot com bubble, but resulted in a positive return for US stocks overall. This notable shift augurs well for 2018, as capital markets are finally functioning as they should.