Knowledge Center Archive
Macro-Dominated Markets and Spiking Correlations: Current Challenges and Future Opportunities
On September 24, 2010, The Wall Street Journal published an article titled "‘Macro’ Forces in Market Confound Stock Pickers." The piece focuses on how macroeconomic themes are currently a driving force in U.S. financial markets, much to the frustration of stock pickers. As a result, traditional methods used to determine stock selection (such as strong fundamental research) have taken a back seat to buying or selling stocks based on interpretations of broader issues involving areas such as politics or the economy.
The Implications of Spiking Correlations
The current focus on macro themes, which has been strong and growing throughout this year, is one of the many market factors SEI routinely monitors. When market movements are heavily influenced by macroeconomic trends, it becomes important to note if stocks are consistently moving in lockstep. Correlation is a measure of these movements. Recent geopolitical concerns have caused stocks to move together to a degree that has raised the eyebrows of even the most seasoned investment professionals. This signals that investors are not differentiating between attractive and unattractive stocks. It’s a phenomenon that occurs when correlations spike in either rising or falling markets.
Our research suggests that bad companies become overvalued as a rising market lifts stock prices across the board. The reverse is true when markets are falling, as good companies become undervalued as their values decline in tandem with the overall direction of the market. We have found that such spikes present strong opportunities for bottom-up, fundamental-selection managers. At SEI, this translates into a compelling opportunity set for active management. We saw this type of scenario in the fourth quarter of 2008, as shown in
Exhibit 1: Correlation Among Stocks in the Russell 1000 Benchmark (1926 – August 2010)
Click image to enlarge
During the fourth quarter of 2008, our combination of statistical analysis and continuous conversations with investment managers led us to increase our weight to managers that we expected would be rewarded during a recovery—a move that proved highly successful when markets rebounded in 2009 and undervalued stocks rose. Notably, even the investment managers that enjoyed significant success in 2009 are quick to point out that conditions today are different. Last year was a unique point in history, with a much broader opportunity set and much more attractive valuations than those seen today.
While past performance is no indication of future results, we nonetheless have noted that correlations among stocks have spiked once again, approaching levels seen in the fourth quarter of 2008. We believe this creates opportunity for skilled investment selection and, where appropriate, we have tilted our portfolios toward investment managers that tend to fare well during these market conditions.
Importantly, while investors often believe “fare well” to mean “positive performance,” the phrase can also refer to loss mitigation. Risk management is a critical component of portfolio construction and management at SEI. While we seek to generate positive results, we also endeavor to create consistency. We tilt our portfolios at the margins in an effort to “smooth out the ride,” as opposed to whipsawing our portfolios by chasing performance. Accordingly, if markets are in decline, or a given strategy is out of favor, we will adjust our portfolios in an effort to help minimize downside participation.
The Importance of a Multi-Manager Approach
At SEI, one of the factors we consider when we evaluate investment managers is their potential for generating alpha in various economic conditions. While some of the investment managers in our strategies are expected to perform well under the current economic conditions, we need to maintain diversification, as well as position our portfolios for what we expect the environment to look like in the future.
For example, The Wall Street Journal article mentioned that Neuberger Berman (an investment manager in SEI’s EAFE and large-cap mandates) previously managed to outperform the S&P 500 using a traditional stock-picking methodology—but with noticeably increased volatility due to macroeconomic movements. Our active-management policy allows us to identify which managers are expected to perform well in different economic environments, and to balance the allocations across the managers in our portfolios accordingly. We keep in mind that our goal is deliver more consistent performance over time, not chase currently “hot” market segments or strategies.
Macro directions are hard to predict, as are overall shifts in the general economic landscape. For this reason, most investment managers focus on security selection. While we have exposure to macro strategies where available, the challenges in predicting market movements—particularly when they are driven by investor sentiment and other factors above and beyond fundamentals—are precisely why multi-manager diversification is critical to an investment portfolio, and why our tilts toward a given strategy occur at the margins. We do not want to chase performance. Rather, we want to add value through strategic positioning when the opportunity to do so in a cost-effective manner arises. SEI believes that active management, in the form of identifying and acting on investment managers’ strengths (and weaknesses) in specific market situations, can lead to healthy portfolios that can adapt to various economic environments.
It is our opinion that the current disconnect in the market cannot persist indefinitely. At some point, divergence will occur as the market begins to recognize and trade on fundamentals. Good, solid companies will be valued accordingly. Troubled firms will suffer. Fundamental stock-picking skills will again be recognized. Accordingly, we have a current bias toward selection-oriented managers, as we hope the seeds they are planting today will bloom in the future.
This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the Funds or any stock in particular, nor should it be construed as a recommendation to purchase or sell a security, including futures contracts. There is no assurance as of the date of this material that the securities mentioned remain in or out of SEI Funds.
For those SEI Funds which employ the ‘manager of managers’ structure, SEI Investments Management Corporation (SIMC) has ultimate responsibility for the investment performance of the Funds due to its responsibility to oversee the sub-advisers and recommend their hiring, termination and replacement. SIMC is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co. (SIDCo.) SIMC and SIDCo are wholly owned subsidiaries of SEI Investments Company.
To determine if the Funds are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Funds’ prospectuses, which can be obtained by calling 1-800-DIAL-SEI. Read them carefully before investing.
There are risks involved with investing, including loss of principal. Current and future portfolio holdings are subject to risks as well. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Narrowly focused investments and smaller companies typically exhibit higher volatility. Bonds and bond funds will decrease in value as interest rates rise. High-yield bonds involve greater risks of default or downgrade and are more volatile than investment-grade securities, due to the speculative nature of their investments.
Diversification may not protect against market risk. There is no assurance the objectives discussed will be met. Past performance does not guarantee future results Index returns are for illustrative purposes only and do not represent actual portfolio performance. Index returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index.
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