Global Stock Correlations Plunge as Morgan Stanley Buys

The lockstep moves in global stocks that dominated equity markets for the past six years are breaking down at the fastest rate on record, a sign investor confidence is finally returning from the financial crisis.

A measure of how much the 2,073 companies in the FTSE All-World Developed Index swing in unison has dropped 31 percent since June, the biggest retreat since at least 1993, according to data compiled by Societe Generale SA and Bloomberg. The indicator ended last month at the lowest level since 2007.

Equities are responding to earnings and merger speculation again after being pushed up and down by events from the credit freeze to Europe’s debt crisis to the stalemate in U.S. budget negotiations. Diminishing correlation was a buy signal in 1998 and 2003 and has coincided this year with the biggest January rally for the Standard & Poor’s 500 Index since 1997, according to data compiled by Bloomberg.

“If you are a good stock-picker or an event-driven picker, your added value is rewarded as opposed to all stocks going up or down the same way,” said Jose Gonzalez-Heres, who helps oversee $15 billion as a manager in the hedge-fund team for Morgan Stanley Alternative Investment Partners in West Conshohocken, Pennsylvania. “This is the first time we see a persistent trend of declining correlation.”

Returns Diverge

The reading, a measurement of how much returns in individual stocks are attributable to swings in the broader market, stood at 32.4 at the end of last month, down from 47.2 in June, according to Societe Generale in Paris. The drop was the biggest since the data started in 1993, indicating stocks are moving with greater independence.

The index reached a high of 49.6 in December 2011. A reading of 100 indicates shares are trading in lockstep.

The divergence in returns is prompting Morgan Stanley to send more money to managers who buy stocks based on profit growth and takeover odds, Gonzalez-Heres said in a telephone interview on Jan. 16. Bears say the improvement will be temporary as U.S. lawmakers confront March deadlines on spending plans and elections are held in Italy and Germany.

Equities rose last week, with the S&P 500 climbing 1.1 percent to 1,502.96, exceeding 1,500 for the first time since 2007, as better-than-estimated jobless claims and profits showed the world’s largest economy is improving. The gauge is up 5 percent this year. The equity benchmark declined 0.4 percent to 1,497.15 at 10:19 a.m. New York time today. The FTSE All-World Developed Index rose 1.1 percent last week to the highest level since 2008.

Daily Swings

Weakening correlations are reducing daily swings in the S&P 500. The benchmark gauge for American equities has gained or lost an average of 0.42 percent per day in 2013, compared with 0.59 percent in 2012 and 1.74 percent during the credit crisis of 2008, data compiled by Bloomberg show. This year’s average matches the lowest annual level since 1993.

Loosening ties among shares mean company news is having a greater impact. DuPont Co., the biggest U.S. chemical maker by market value, climbed 1.8 percent on Jan. 22 after earnings exceeded projections.

That compares with Jan. 24, 2012, when the Wilmington, Delaware-based company lost as much as 1.2 percent even after releasing first-quarter earnings that topped estimates. The S&P 500 fell 0.1 percent that day on a report that showed sales of previously owned U.S. homes unexpectedly dropped.

Monsanto Co. rose 2.7 percent on Jan. 8 after reporting first-quarter results that were higher than analysts predicted. When the world’s largest seed company said in April that quarterly profit exceeded estimates and raised its full-year forecast, the stock slid 1.5 percent amid a 1 percent decline in the S&P 500 that followed a disappointing Spanish bond auction.

Stock Pickers

“A stock picker’s market is one where there’s real distinction between winners and losers,” Jeffrey Davis, who oversees $5 billion as chief investment officer at Lee Munder Capital Group in Boston, said in a Jan. 24 phone interview. “Investors are much more aggressive about individual equity selections now, rather than looking for top-down trends.”

They’re also getting more bullish. More than 50 percent of institutional investors polled this month said equities will offer the highest returns in the next year, the most since the quarterly survey of investors, analysts and traders who subscribe to Bloomberg began in July 2009.

Diverging prices have accompanied rallies in the past and the same thing is poised happen now, according to Fidelity Worldwide Investment. As correlations in the FTSE All-World Developed Index dropped to 12.4 in March 2000 from 28.3 in September 1998, the S&P 500 rallied 57 percent.

Record High

The gauge of market influence slipped to an almost five-year low of 20.8 in April 2006 from 34.7 in May 2003 as the S&P 500 surged to an all-time high of 1,565.15, reached in October of the next year.

“Falling correlations will help the equity prices of the stronger business with attractive long-term prospects,” Paras Anand, who helps oversee $240 billion at Fidelity in London, said Jan. 24. “Typically this churn process will be positive for equity prices.”

Lower correlations won’t last because threats to the global economy haven’t disappeared, according to Supriya Menon, who helps oversee $400 billion as a strategist at Pictet & Cie. in Geneva.

In the U.S., Republicans plan to use two approaching deadlines -- the March 1 start of automatic spending cuts and the need to pass a bill by the end of that month to fund the government -- to extract spending reductions from President Barack Obama and congressional Democrats. Congress agreed to suspend the $16.4 trillion debt ceiling until May 19 to prevent a default.

Italian Elections

Policies aimed at preserving the euro face referendums as the governments of Italian Prime Minister Mario Monti and Germany Chancellor Angela Merkel are challenged in elections this year.

Earnings growth is projected to slow this quarter and the International Monetary Fund cut its forecast for 2013 global economic expansion this month to 3.5 percent, 0.4 percentage point lower than its July 2012 estimate.

“Given our macro view of the world, you should see correlation spikes during those periods of stress, which we don’t think are behind us,” Menon said in phone interview on Jan. 23. “There are risks that are not completely reflected in the price of risk assets. Given where sentiment is, things are ripe for a correction.”

Confidence Climbs

Individual investors are showing increasing confidence in stocks. Money is flowing into equity mutual funds after four years in which assets fell by almost $250 billion. The withdrawals came after the financial crisis erased $11 trillion in American equity value, market malfunctions spurred rapid declines and the U.S. budget deal debate in 2011 led S&P to lower its AAA rating on the country’s debt.

About $22 billion flowed into stock funds around the world in the week ended Jan. 9, the second-highest rate on record, according to data compiled by research firm EPFR Global going back to 1996. Funds took in money after the FTSE World index posted a 3.2 percent advance in the first week of 2013, while the S&P 500 Index reached a five-year high and Japan’s Nikkei 225 Index extended its longest advance since 1987.

Looser correlations help money managers because they are more likely to be rewarded when their convictions prove correct, said Morgan Stanley’s Gonzalez-Heres. One in three fund managers posted returns that beat the Russell 1000 Index in 2012, while only one in five did in 2011, according to data from Bank of America Corp. on Dec. 26.

Economic Optimism

More than two thirds of the respondents in this month’s Bloomberg Global Poll said they plan to raise their holdings of equities in the next six months, while twice as many respondents said the global economy is getting better than those who said it’s worsening, the data show.

The Chicago Board Options Exchange S&P 500 Implied Correlation Index, which uses options to measure expectations about whether S&P 500 companies will move in unison next year, shows traders are betting the links will keep weakening. The gauge has fallen 22 percent since June and reached 59.76 on Jan. 2, its lowest level since November 2010.

Weakening ties among shares indicate investors are less concerned about economic headlines and are betting that corporate profits will determine their investment choices, according to Jason Collins, London-based head of European equity at SEI Investments Co. Almost 70 percent of American and European companies are forecast to post higher earnings for the next 12 months, according to Bloomberg data on about 3,000 companies with market values of at least $1 billion.

“Equity correlation tends to spike at times of crisis or distress as investors’ macro concerns swamp individual company fundamentals,” Collins, whose firm has $195 billion under management, wrote in a Jan. 24 e-mail. “As correlation falls and stock performance starts to better reflect fundamentals, then stock picking should once again be rewarded.”

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