Triple Crown: Triumvirate of Tailwinds Blow in Active Managers’ Favor

Active managers are experiencing the market’s own version of a triple crown, as a triumvirate of tailwinds blow more heavily in their favor than at any point in the past several years.

In sports, the triple crown is a highly coveted and exceptionally rare feat. Only 12 horses have won racing’s version of the triple crown. Baseball players have achieved the feat (leading the league in home runs, batting average, and RBIs in the same season) only 17 times. Market statistics don’t line up quite as neatly – there’s no marking the end or beginning of a new “season” – but three factors that gauge the backdrop for active management are in leading positions not experienced in several years.

Each quarter, we assess the market conditions for active management in our Wall Street Mood Monitor, a model that measures the climate based on three factors: correlations, sentiment and earnings trends. Conditions have rarely been as favorable as they were in the fourth quarter. All three factors hit new multi-year — or even decade-long — levels. Below, we shed light on the rare territory in which each factor currently sits.

Correlations find new lows

The most impressive change within this quarter’s Mood Monitor may be the dip in intra-market correlations, which are now 20% below any level we have measured in 15 years. Over the past year, the average correlation between stocks has declined to only 0.29. That’s more than 40% below the average correlation observed since 2002.

Beneath market-level correlations, we found that every sector is experiencing lower-than-normal intra-sector correlations, with the consumer discretionary and health care sectors experiencing the lowest intra-sector correlations relative to their long-term averages.

Pundits may ascribe the dip in correlations to several potential factors: low market volatility, ebbing flows into passive, dramatic disparity between growth and value factors, or tax reform’s varying impact on individual companies. Whatever the reason, the market appears to be taking a more discerning view on individual companies, and such environments tend to help active managers.

Earnings trends are more favorable than at any point in the last 15 years

We assess earnings trends by comparing the number of one standard deviation earnings beats to one standard deviation misses.

In the fourth quarter, 55% of companies beat their consensus estimates by at least one standard deviation. The high rate of substantial earnings beats eclipsed the third quarter total (54%) and is close to the 15-year high established in June.

Meanwhile, only 11% of companies reported earnings substantially below their consensus estimates, which approaches the nadir reached in 2010.

By another measure, this may have been the best corporate earnings season in our 15 years of collecting data. The spread between companies reporting one standard deviation beats and one standard deviation misses is now the widest we’ve ever recorded.

Analyst sentiment is most positive since 2011

Our third factor assessing active management conditions is sentiment. We gauge sentiment by comparing the sum of corporate earnings estimates that Wall Street analysts revise upward in a given period to the sum of earnings estimates revised downward.

This quarter, we saw the proportion of earnings estimates adjusted upward improve each month. In December, 62% of all revisions were upward adjustments, marking the highest level of upward revisions since 2011.

The overwhelmingly positive view from analysts marks a step change in sentiment from last quarter, when the ratio of upward and downward revisions was neutral in July and August, and more negative in September.

Taken in tandem, ultra-low correlations, highly positive earnings trends and strong sentiment have created a highly conducive market environment for active management. Wall Street may not keep the same records as sports historians, but today’s rare conditions seem as remarkable as a triple crown.

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