This Little-Known Index Has Great News for Stock Pickers

Stocks are sinking this morning, with the S&P 500 (SNPINDEX: ^GSPC  ) and the narrower, price-weighted Dow Jones Industrial Average (DJINDICES: ^DJI  ) down 0.62% and 0.51%, respectively, as of 10 a.m. EST.

The index no one talks about
This column has devoted quite a bit of attention to the collapse of volatility, as measured by the "fear index" -- the CBOE's VIX (VOLATILITYINDICES: ^VIX  ) . However, this is the first time we mention a related phenomenon: the decline in correlations. Just as the VIX measures investors' expectations for short-term volatility in the S&P 500, the CBOE produces several Implied Correlation indexes that measure the expected average correlation between the returns of stocks in the S&P 500 index. The following graph shows how the Implied Correlation Index with a January 2014 maturity has evolved from the end of 2011 through last Friday:

Source: CBOE.

As the graph indicates, the current index dipped below 60 in January for the first time since the end of 2011 (in fact, since its inception in November 2011). For reference, the equivalent index averaged only 45 in 2007; correlations then shot up in the wake of Lehman's bankruptcy.

What does this mean for investors? When correlations between stocks are very high, the only factor that determines portfolio returns is whether or not one is invested -- that is, the amount of stock market exposure, rather than which stocks create that exposure. In that environment, taking care to select individual stocks does little or nothing for current returns, but it can have a massive impact on long-term returns -- once correlations normalize.

As stock correlations now appear to be declining, talented stock-pickers will begin to see the rewards of their insight and patience over the last few years as returns among individual stocks begin to diverge in response to company-specific factors. Stock pickers, your day is coming.

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