The below chart shows the average 60 day correlation of equities within four different sectors. It looks like many of the sectors are reacting to company specific news again, not just news about the business cycle. If correlations stay low, this is good news for stock pickers who can try and pick the outperforming stocks instead of having their particular stock act like every other stock in the market.
Source: Palantir Finance
However, if there is a downturn in the market then correlations between equities will jump. This is because of data sampling issues – even if two assets are driven by the same major underlying trends, they won’t move together unless the major trend is changing. One way to look at this effect is to look at the correlation between the stock market indices for the United Kingdom and Japan.
Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX, the stock market volatility index of the US’s S&P 500 market, is under 20. When things are calm in the world the correlation is rather low at 0.29.
Weekly returns of UK’s FTSE vs. Japan’s Nikkei when the VIX is over 20. When the VIX is over 20, signaling that the US market is adjusting to a significant information flow, then the correlation between these two markets is much higher at 0.52. In more volatile time periods, stocks and stock markets are more likely to be reacting to the same information so their correlations are going to be higher.
Source: Palantir Finance
Right now, the VIX is a bit under 18, helping explain why correlations are low again. In a market downturn, stock pickers will be hit with the double whammy of falling prices and a smaller diversification effect. Stock pickers can partially avoid this problem by picking lower beta stocks which have tended to outperform in the long run due to their relatively strong performance during downturns, but then they would be missing out on a lot of the returns of the recent rally.