Correlations Spoil the Party for Active Managers

Active managers were able to ring in the new year with some of the most favorable market conditions for stock picking on record. Spiking correlations in the first quarter have officially spoiled the party.

Each quarter, we assess the market conditions for active management in our Wall Street Mood Monitor, a model that gauges the climate based on three factors: correlations, sentiment and earnings trends. As we shared in our fourth quarter report, all three factors hit or approached new multi-year — or even decade-long — highs.

Sentiment and earnings trends remained favorable in the first quarter, but a jump in intra-market correlations erased 18 months of steady correlation declines. Intra-market correlations now sit near their highest levels since 2016. For perspective on how dramatically correlations have changed, consider that at the end of 2017 intra-market correlations were 20% below any level we had measured in 15 years.

Intra-sector correlations are now at above average levels in every sector. For the technology and financial sectors, correlations are at levels not experienced since the early recovery years after the financial crisis.

Sentiment and Earnings Trends Remain Positive

While spiking correlations were the big story this quarter, two other factors we measure — sentiment and earnings trends —remained positive. We measure Wall Street analyst sentiment by comparing the total number of upward and downward revisions analysts make to their earnings estimates.

In January, 74% of analyst earnings estimate changes were upgrades, a record level for the last 15 years. Corporate tax reform likely had a heavy influence on earnings revisions in the month. In February and March, upward earnings revisions continued to exceed downward revisions at some of the highest rates since 2012.

Earnings trends were also upbeat: Fifty-two percent of stocks beat consensus earnings by at least one standard deviation this quarter, a percentage not far from record highs we’ve recorded over the last 15 years. Only 12% of companies reported earnings one standard deviation lower than consensus expectations, which remains near the lowest levels recorded since 2010.

While firm earnings trends and positive sentiment are supportive of active management, correlations will have to dip considerably to make the environment as conducive as it was through much of 2017.

To read more about the market conditions currently facing active managers, read our first quarter Wall Street Mood Monitor.