Peter Lynch's Era Recalled as Stock Correlations Break Down

  • About 90% of active managers have beat Russell 2000 this year
  • CBOE gauge of expected correlation falls to lowest 2016 level

The U.S. equity market is returning to an era when stock pickers reigned, at least according to one strategist.

Lockstep moves in equities that crippled active managers in the recent past are loosening, as a measure of implied correlation among U.S. stocks has plunged from a four-month high in mid-February to the lowest level of the year. That should help boost the performance of investors who select shares based on idiosyncratic characteristics, said Bank of Montreal’s Brian Belski, for whom the current climate recalls the 1980s when Peter Lynch and Warren Buffett rose to fame.

After the worst-ever start to a year for U.S. equities left few corners of the market unharmed, active managers have reason for optimism as anxiety eases and investors shift attention to individual stocks. As gains in beaten-down shares have contributed to the recent rebound that’s restored $1.5 trillion to U.S. shares, so-called value shares have outperformed as investors seek bargains.

“It’s the era of active investing,” Belski, chief investment strategist at Bank of Montreal, said on March 2 on Bloomberg Radio’s “Surveillance.” “It’s a Warren Buffett or Peter Lynch-type world where you buy good companies and stick with them.”

Lynch, the legendary Fidelity Investments fund manager who returned almost 30 percent a year in the 1980s, and Buffett, the Berkshire Hathaway Inc. chief executive officer whose shares have beaten the market by more than 10 percentage points a year for five decades, famously made long-term bets on companies they determined the market had undervalued.

Such opportunities may be reemerging, Belski said, as the collapse in stock correlation threatens to end a six-month run of equities moves that saw markets careen higher or lower based on shifts in risk appetite.

The breakdown can be seen in a Chicago Board Options Exchange index that uses options to measure expectations of how much U.S. equities will move in unison. The CBOE S&P 500 Implied Correlation Index slipped on March 3 to the lowest level of 2016, after hitting a four-month high on Feb. 12. It currently trades about 7.5 percent below its five-year average, data compiled by Bloomberg show. The S&P 500 slid 1.1 percent to 1,979.26 at 4 p.m. in New York.

After the S&P 500 tumbled as much as 11 percent on a closing basis this year, bargain hunters have stepped in. An index of value stocks in the benchmark gauge has seen a jump of more than three times that of its growth-oriented counterpart since the start of February, Bloomberg data show. That’s the widest margin of outperformance for the value group since April 2014.

To John Carey of Pioneer Investment Management Inc., the surge in value stocks highlights the comeback of finding quality names within beaten-up sectors rather than picking the potentially fastest growth stocks in favored groups.

“Investors are beginning to look again at the whole market and all the different sectors, seeking companies that have a good chance of growing earnings,” said Carey, a Boston-based fund manager at Pioneer, which oversees about $230 billion. “It becomes important to identify the high-quality stocks with stable financial characteristics. It’s a market in which one needs to be selective.”

This is welcome news for fund managers whose objective is to beat benchmark averages because, in theory, it increases their opportunities to find big, relative winners. It’s also a departure from the monolithic trading that dominated last year.

About 90 percent of active money managers have beaten the Russell 2000 Index so far in 2016, compared to just 43 percent over the last 10 years, according to data compiled by Morningstar Inc. The same outperformance has been seen in the Russell 1000 and 3000 indexes, with year-to-date returns for active investors doubling the 10-year averages for both measures, the data show.

Meanwhile, an easing of investor fears can be seen in the CBOE Volatility Index, which has been below 20 for the past five days, falling 16 percent over that period. The gauge of price swings has plunged 38 percent since Feb. 11, the day the S&P 500 decreased to a 22-month low.

Ray Dalio, who runs Bridgewater Associates LP, the world’s largest hedge fund, said investors should expect low returns, but that stock pickers will outperform.

Investors should be concerned with creating a “good strategic asset allocation mix that is a balanced portfolio,” rather than betting against active investors, he said an interview with Bloomberg Television on March 3.

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