Inter-Sector Correlation The Lowest Since The Tech Bubble

The correlations between sectors have declined in the past few months. This means the market is bifurcated. To uses a common Wall Street phrase, ‘it’s a stock pickers market’.

The correlations may have fallen in 2000 because only the tech stocks were going up. During the financial crisis, all stocks fell which is why correlations were high. An interesting dynamic to consider is that correlations are declining despite all the passive investors buying S&P 500 index funds. It makes you question how much the indexing is affecting the market.

The big question is if this current situation is going to lead to the same crash that occurred in 2000. I don’t see that happening because tech stocks are much cheaper this time around. I can’t think of a sector which is due for a major crash. There will be times of underperformance like I think might happen in oil in the next few weeks, but that would be nothing compared to the collapse in 2014-2015. As you can see, the correlation was low in 1995, yet a crash didn’t occur. This is likely one of those charts which gets famous because of a comparison to a crash period, but doesn’t forecast a crash correctly.

One of the catalysts of the decline in inter-sector correlation is the impact of tax policy. As you can see, firms with high tax rates which will benefit the most from the corporate tax cut have recently started to rally. The high tax stocks and the financials have been outperforming the S&P 500 in the past few weeks. The legislation will likely be priced in, in the next few weeks which means the correlation might return to more normal levels in the 2018.

For the last point on the tax cut, the chart below shows the corporate tax rates of many developed nations. As you can see, the U.S. corporate tax cut to 20% moves it from the highest taxed country to one of the lowest. This is just the statutory rate, not the effective rate. I think America is probably closer to the others in actual taxes paid before this legislation gets passed. The French are also cutting corporate taxes. They are also lowering government spending. The 33.33% corporate tax rate will gradually be cut over the next few years. It will fall to 28% in 2020 and 25% by 2022.

The Risk Factors Headed Into 2018

Let’s look at some more points in the list of the biggest risks for 2018 created by Deutsche Bank. The fourth risk is the new Fed leadership being tested. It wouldn’t be surprising to see Powell tested early since running the Fed is always a challenge. The biggest likely test will be how he deals with accelerating inflation in 2018. The best plan would be to avoid overreacting. The change at the Fed isn’t just at the top. As you can see from the chart below, the Fed had lost a lot of its bankers in the 1940's. The number of academics has increased starting in the 1950's. With Trump’s preference for private sector economists, the number of academics and research economists should fall and the number of bankers should rise. The result on policy is unknown. It’s impossible to draw conclusions by looking at what policy was put in place in the 1920's because the role of the Fed has changed.

Getting back to the list, it questions if Powell will be driven by politics or the data. I think this is a naive question because policy is always driven by politics. It’s also driven by the returns of the stock market. Regardless what is causing policies to be put in place, the main question remains what they will be. If this is suggesting Powell would purposely tank the economy because of ideological reasons, I think that won’t be the case based on his track record. The Fed chair who would have done that is Warsh.

The fifth risk is German inflation beating expectations. German inflation stalled in 2017 as the inflation rate in January 2017 was 1.9% while the inflation rate in November was 1.8%. The big increase in inflation occurred in 2016. The German unemployment rate was 3.6% in October which is the lowest rate since 1980. That could catalyze wage growth which is listed as the 6th risk. This could spur inflation. Inflation could spur political tensions as the Bundesbank complains to the ECB about its bond buying program causing inflation. However, I think that ship has mostly sailed. The tensions peaked in 2016 when German inflation was picking up and the ECB had its bond buying program going at full throttle. Now the ECB is winding down the program. You’d think the risk listed would be German deflation, not inflation.

The seventh risk is negative rates on European government bonds coming to an end. That’s a funny risk because many investors thought the bonds going to negative rates was a risk. Now the risk is normalization. Higher rates would be problematic for some European governments since they would increase deficits. The increase in European government bond yields could cause an increase in bond yields in American markets which would lower earnings multiples. Essentially, the point made is that the end of the central bank stimulus programs will hurt stocks. The answer to how much stocks will be hurt by the ECB’s tapering depends on how healthy the economy is and if corporate earnings meet expectations.

Conclusion

I don’t think the decline in correlation among sectors means anything. However, I could be wrong. Besides the potential of being wrong, the fact that the rise of indexing hasn’t prevented the decline of correlations is interesting. I do think the ECB taper will affect stocks, but I’m far from being in the camp that says a crash is a lock. I don’t think Powell will go rogue and enact policy which destroys investor confidence. Nothing that he has publicly said would lead me to believe that.