We remain cautious on US large cap stocks over the very near term (1-2 weeks) even with the recent snapback rally from the December 1st lows. To be clear, we’re not bearish. It’s just that markets have their own cadence and respecting that fact tends to lead to better investment and trading decisions.
Case in point: consider US large cap equity sector correlations to the S&P 500 index. During periods of rising prices, these tend to decline. Investors and traders see rallies as times to make targeted bets on winners and losers, so some sectors do better than others on any given day. But … When equity asset prices drop suddenly, such as in the week after Thanksgiving this year, correlations rise equally quickly. There are no safe harbors in terms of major sectors when the tide of investor sentiment turns suddenly.
This 3-year chart shows 30-day average sector correlations relative to the S&P 500 for 5 large groups in the index: Technology, Health Care, Communication Services, Consumer Discretionary, and Industrials. You can see the ebbs and flows of investor confidence in this data:
- When correlations are above average (0.82), you know the S&P is having a rough time. Correlations over this period peaked, for example, at an astounding 0.99 during the March 2020 meltdown.
- Conversely, when correlations are falling and below 0.70 (all those spiky lows), you know animal spirits are out in full force. Note especially how correlations have generally made lower lows since the start of 2021 (the last 5 v-bottoms to the right of the graph).
Now, over the last 30 trading days (not including today), average sector correlations are fairly high at 0.79. That’s way off the lows of 0.59 for the 30 days ending the day before Thanksgiving. No surprise there because correlations rise when stock prices decline quickly, as noted previously.
But here’s the problem: correlations aren’t quite high enough to confidently call a near term low:
- At 0.79, they are below the long run average of 0.82.
- And, as we note in the chart, they are also below prior solid entry points.
- For example: remember how the S&P finally shook off its September blues in early October? Correlations then were 0.86 – 0.87, the last large spike top you see on the rightmost part of the chart above.
- That early October high for correlations was the foundation for the S&P 500’s 8 percent rally through early November. This, in other words, is the right set up for a sustainable move higher.
We think the CBOE VIX Index at 21.6 (today’s close) is another indication that we haven’t gotten the “all clear” sign just yet. Remember the VIX is a 30-day indicator, and the last week of December is usually a low point for this measure of near-term volatility. The fact that the VIX is still above its long-run average (20) tells us options markets are thinking next week may see one final spurt of market volatility.
That, of course, lines up with the last FOMC meeting of the year next week so it makes sense the VIX would linger above 20 even if everyone knows it decays quickly from Christmas to New Year’s Eve. How markets respond to a more-hawkish communique, “Dot Plot”, and Chair press conference is hard to know. Our bet is the combination of these factors will increase both volatility and sector correlations (and the two are mathematically tied to each other). Once we get past that, US equities should have a clear path to rally into the end of the year.
Takeaway: the correlation math we’ve presented today makes a solid case for remaining cautious at least into next week, for the simple reason that we never got a clear “buy” signal ahead of the recent recovery in stock prices.