It’s 9:30 in the morning at the New York Stock Exchange.   A man presses a button that rings a bell and opens the exchange for business.   Behind him is a giant billboard with 500 individual lights.  Each light represents one of the 500 stocks in the S&P Index.  On a typical day 485 bulbs may flash green signifying stocks that are going up … at least for the moment; the other 15 flash red signifying stocks that are going down … also for the moment. This almost universal up move could be reversed the next day … or even within minutes from the opening.  This is the world of correlation! 

Correlation is the degree to which stocks move up or down together relative to the S&P 500 Index.  It is a stock picker’s worst nightmare; a stock trader’s (gambler’s) best friend.  The stock picker believes that some businesses are better than others and thus worth more.  And, of course, some are.  The trader could care less; his bet is on the immediate direction of stocks as an asset class.  Understandable, in periods of great stress – such as the crash of 1987 – stocks had a correlation of 88% to the downside.  What has been surprising - and new in the past five years – is seeing a similar correlation in an up market.  When stocks are trading as commodities it is virtually impossible to beat the S&P 500 Index.  After all, pork bellies are … well … pork bellies!  One pork belly contract isn’t different than another. 

High correlation is always caused by a macro event.  The event this time was the debt collapse of 2008-2009.  The ongoing fear – and intermittent optimism – has led stock trading to become one asset class for the past five years.  It’s the source of what has become known in the hedge fund world as the “Risk-On/Risk-Offtrading strategy.  But why has such strong correlation continued for five years?   

I believe it is because of the meteoric rise of Index Funds and ETFs (exchanged traded funds).  ETFs alone in the past five years have grown from 500 billion to 1.7 trillion!  And therein is a potential future problem that will confound individual investors.  They have been repeatedly told that no one can beat the stock market and have bought into a new investor paradigm of Index Funds and ETFs.  But the underlying premise of the paradigm is not true.  What hasn’t been told is that performance comes “lumpy.”  One good year can make up for two or three mediocre years.  It is true that no one can consistently beat the S&P 500 every year.  Warren Buffett has lagged the market for the past five years.  But it is not universally true … which is how it’s been presented by Wall Street firms selling the products.

There are very few things that one can say unequivocally.  But Financial Times writer, Gillian Tett, had it “nailed” the other day when she wrote … “The one thing that is clear is that, whenever there is blind faith in any single paradigm, that paradigm will eventually fail.” The current paradigm is: Index Funds and ETFs are the only way to invest. That assumes every company’s stock has the same future and that no one can beat the market.  Neither assumption is true.

What would upset the current paradigm?  Answer:  Rising interest rates.  In 1966 Fed Funds were 4% and the Dow Jones touched 1,000.  Sixteen years later Fed Funds were 19% (admittedly a period of high inflation) and the Dow Jones was still 1,000.  It was a period of cyclical bull and bear markets going nowhere for sixteen years.  But it was also a period of great growth stocks!  Fed Funds are now 00.25%.  What happens when Fed Funds simply “normalize” at 4.00% to 4.75%?  As Mark Twain once said, “History doesn’t repeat itself but it does rhyme.”          
            

Francis Patrick Boland

6-11-14