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Greed Beats Fear With Stock-Bond Correlation Falling

U.S. Federal Reserve Chairman Ben S. Bernanke
Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Hannelore Foerster/Bloomberg

For the first time since the financial crisis started, U.S. shares are moving independently of the bond market, a sign that profits and valuations are guiding investors more than concern about the economy.

The 30-day correlation coefficient measuring how often the Standard & Poor’s 500 Index moves in tandem with 10-year Treasury yields fell to minus 0.42 from a record 0.89 in June, data compiled by Bloomberg show. Readings of 1 indicate prices are moving together, while zero shows no link and minus 1 means they are going in opposite directions. Stocks and debt are ending a lockstep relationship that began in July 2007 and lasted through the worst recession since the 1930s.

Pioneer Investments, Security Global Investors and Citigroup Inc. say the broken connection is bullish as the greatest number of S&P 500 companies in a decade post earnings growth. During the bull market from 2002 to 2007 when the S&P 500’s price and profits doubled, the correlation averaged 0.15, data compiled by Bloomberg show.

“I prefer days when companies are rewarded or punished based on their performance,” said John Carey, a Boston-based money manager at Pioneer, which oversees about $250 billion. Before, “people were worried that some large events over which they had no control would influence the direction of the market and investment results,” he said.

Bernanke’s Pledge

The S&P 500 rose less than 0.1 percent to 1,199.73 last week as China took steps to curb inflation. The index has advanced 13 percent since Federal Reserve Chairman Ben S. Bernanke hinted on Aug. 27 in Jackson Hole, Wyoming, that he would use a strategy known as quantitative easing to boost the economy. The relationship between the 500 stocks and the benchmark index fell to 0.55 on Nov. 11, the lowest since May 3, according to Birinyi Associates Inc. data on 50-day correlation.

The S&P 500 slipped 0.2 percent to 1,197.84 at 4 p.m. in New York today.

The relationship using 30 days of data between the S&P 500 and 10-year Treasury yields was last negative in July 2007. It jumped to 0.79 on Aug. 14, 2007, five days after Paris-based BNP Paribas SA halted withdrawals from three investment funds because it couldn’t value their holdings as U.S. subprime mortgage losses roiled credit markets. The stocks-bonds relationship never turned negative in 2008.

After Lehman

The S&P 500 plunged 4.7 percent and yields on 10-year Treasuries tumbled 33 basis points, or 0.33 percentage point, on Sept. 15, 2008, after New York-based Lehman Brothers Holdings Inc. filed for bankruptcy. The correlation jumped to 0.83 on Oct. 6, 2008, as the financial crisis intensified, reaching the highest level since a month after the Iraq War began in 2003, data compiled by Bloomberg data show.

Bernanke’s Aug. 27 comments helped end the lockstep moves. Weaker connections among assets mean profits, takeovers and valuation will drive returns, Security Global’s Mark Bronzo said. The S&P 500 climbed to a two-year high on Nov. 5 and the rate on 10-year Treasuries dropped to the lowest level since 2009 on Oct. 8.

While Howard Ward of Mario Gabelli’s Gamco Investors Inc. says stocks are likely to rally, loosening correlations aren’t fueling his optimism.

‘Real Perceived Difference’

“The correlation is moving lower because of what’s now a real perceived difference in the return potential for stocks versus bonds,” said Ward, whose firm oversees $26 billion in Rye, New York. “I understand people are very anxious about stocks because of volatility, because of economic uncertainties and because they didn’t do well for the last 10 years, but buying bonds today is like buying stocks in 1999,” before the S&P 500 plunged 49 percent, he said.

Treasuries returned 81 percent between 1999 and 2009 while the S&P 500 dropped 9.1 percent, including dividends, for its first loss over the course of a decade, according to data compiled by Bank of America Corp.’s Merrill Lynch and Bloomberg.

As correlations break down, quarterly financial results are swaying share prices more than at any time since 2007. S&P 500 companies that beat the average analyst profit forecast gained 0.1 percent since reporting results, while those that missed declined 3.3 percent, according to data compiled through Nov. 16 by Westport, Connecticut-based Birinyi. That’s the first time in three years companies beating estimates rallied and those that missed fell on average.

Getting Rewarded

“There are those individual names that will produce stronger earnings and profit margins, and will be rewarded for that,” said Bronzo, a money manager in Irvington, New York, whose firm oversees $22 billion. “We’re returning to a more normal economic environment as we’re moving past the financial crisis. So where the market traded all as a group, there’ll be more of a distinction between sectors and names.”

Third-quarter earnings surpassed analyst projections by 6.6 percent for the 457 companies that have reported since Oct. 7, Bloomberg data show. It was the sixth straight period in which more than 70 percent of companies beat forecasts, the longest stretch since at least 1993, according to Bloomberg.

Analysts forecast 87 percent of S&P 500 companies will post higher earnings next year. That would be the most since at least 2000, estimates from more than 10,000 analysts compiled by Bloomberg show.

“There’s a better chance for active managers to outperform,” said Eric Teal, chief investment officer at First Citizens BancShares Inc. in Raleigh, North Carolina, which manages $5 billion. “Over the past few years, many of the macro forces have driven the stock market returns and now more fundamentals are starting to drive the market.”

Stocks, Junk Bonds

Stocks that trade at below-average price-earnings ratios and that trailed benchmark indexes in 2010 -- such as Hewlett- Packard Co. and Merck & Co. -- should benefit as equity returns diverge, Carey said. MFS Investment Management’s James Swanson recommends technology companies because they have money to return to shareholders.

Hewlett-Packard has almost $15 billion in cash, the 12th-highest amount in the S&P 500. While at least 28 of 38 analysts covering the Palo Alto, California-based company recommend investing in the world’s largest computer maker, the stock has fallen 18 percent this year, pushing the valuation down to 8.3 times 2011 estimated profit.

Merck, the world’s second-largest drugmaker, has a price-earnings ratio of 9.2 times next year’s forecasts, Bloomberg data show. The Whitehouse Station, New Jersey-based company is down 3.3 percent this year, compared with the S&P 500’s 7.6 percent gain, even as per-share earnings excluding some items are projected to expand 13 percent next year, the best annual growth since 2007, according to the analyst average.

‘My Goodness’

“My goodness, these are very good prices for these stocks,” Carey said of health-care companies. The 51 pharmaceutical producers, device makers and health insurers in the S&P 500 trade for 12 times annual earnings, compared with a 10-year average of 19.2, data compiled by Bloomberg show.

While the benchmark index for American shares has rallied 77 percent since reaching a 12-year low on March 9, 2009, prices relative to earnings remain below historical levels. More than 88 percent of S&P 500 stocks are cheaper than their average since 2005, based on next year’s forecasts, compared with the decade’s 66 percent mean, data compiled by Bloomberg show.

Takeovers picked up this year, with $651 billion worth of U.S. deals announced since January, compared with $635.8 billion for all of last year, according to data compiled by Bloomberg.

Similar Performance

Stronger correlations made it more difficult for mutual funds to distinguish themselves. The standard deviation, or variation in returns, for funds invested in the biggest U.S. companies declined to 4.1 percent in the second quarter, data compiled by Lipper and Bloomberg show. That was the lowest since at least 2000. The figure climbed to 9.8 percent last quarter as correlations weakened.

Returns among money managers mirrored one another regardless of strategy. An index of hedge funds focused on bonds of distressed companies has returned 8.5 percent this year, according to data compiled by Bloomberg and Chicago-based Hedge Fund Research Inc. Over the same period, a gauge of Latin America funds returned 7.1 percent. The correlation between the two has climbed to about 0.28 point more than the 12-year average, Bloomberg data show.

“More focused investing may be in the process of developing,” Tobias Levkovich, Citigroup’s chief U.S. equity strategist in New York, wrote in a report this month. “As returns begin to diverge, investors arguably can be well-served by buying those stocks they deem attractive without worrying about macro conditions that can swing entire groups.”

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