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NEW YORK, July 5 (Reuters) – US stocks’ tendency to move in sync has plunged to near-record lows, but what might seem like a stock picker’s dream may actually be a mirage, and investors may be in for a rude awakening.

S&P 500 correlation – a gauge of herd behavior, which measures how closely daily returns of index constituents align over a month – slipped to 0.22 at the end of June, close to the lowest since November 2021, according to data from S&P Dow Jones Indices. That means that many stocks are moving in different directions.

Investors expect stocks to move increasingly out of sync as shown by the Cboe 3-Month Implied Correlation Index, which measures the 3-month expected average correlation across the top 50 value-weighted S&P 500 stocks. The Index touched a record low of 17.59 on Wednesday.

That would typically lower risk and offer more opportunities for stock pickers. But with the bulk of the market’s gains being driven by a handful of mega cap names and a crowd of market bets on continued low correlation, investors may be relying on a false sense of calm.

“The risk metrics that look quiescent and favoring idiosyncrasy may in fact be a chimera much more vulnerable to a macro shock than implied currently,” said Arnim Holzer, global macro strategist at EAB Investment Group.

History suggests such narrow breadth can set the market up for a sudden surge of volatility.

“From these low levels of stock correlations, equity volatility has historically risen,” UBS strategists said in a note on Wednesday.

The Cboe Volatility Index, the so-called Wall Street ‘fear gauge,’ which recently closed at it lowest in nearly 3-1/2 years, has generally jumped by 10 points over the coming quarter when 1-year stock correlations have been at the current low levels, the strategists said.

The last time 3-month implied correlation got this low was in early 2018, just before the February 2018 urge in market volatility dubbed ‘Volmageddon.’

The low correlation now is in stark contrast to late last year when investors were laser-focused on macro factors including employment, growth, and inflation, leading stocks to move in sync.

This year, however, with the US Federal Reserve close to the end of its hiking cycle, economic data has lost some of its ability to sway stocks en masse.

Much of today’s low stock market correlation has to do with the gulf in performance between a handful of mega caps driving the benchmark index higher and the rest of the market.

While the S&P 500 has gained 16%, its equal-weight equivalent, which dilutes the impact of the largest companies in the index, has risen just 6%.

That leaves less room to pick winners.

“You have this view in the market that this is a stock picker’s market because correlation is low,” EAB Investment Group’s Holzer said.

“The problem is that this is not that environment,” he said.

For some investors, it also means thinking outside of large caps.

“Given the narrowness of the market so far this year, we suggest investors consider an S&P equal-weight strategy or US mid-caps for cash earmarked for US large caps,” said Jack Ablin, chief investment officer of Cresset Capital.

“History suggests the average stock will ‘catch up’ with the mega caps over the next 12 months,” Ablin said.

COILED MARKETS

One trade that has drawn investors in recent months is the so-called long dispersion trade – where traders sell index volatility while buying volatility on constituents – essentially betting on individual stocks not being strongly correlated, Kris Sidial, co-chief investment officer of volatility arbitrage fund the Ambrus Group.

This, in addition to general selling of volatility as markets skipped higher this year, has crushed volatility and correlations.

“It’s a big pile-on into short volatility and short correlation,” Sidial said.

But that also sets up the stage for a rapid upheaval when the calm breaks.

“When you have one side of the market that has piled into a trade, when that trade unwinds, it can be very rapid,” he said. said.

For investors, the pricing on index hedges that would guard against a big jump in volatility is more attractive than it has been for a while.

“Because correlations are so low, index options have gotten incredibly cheap,” said Daniel Kirsch, head of options at Piper Sandler said.

(Reporting by Saqib Iqbal Ahmed; Editing by Megan Davies and Nick Zieminski)

 

NEW YORK, July 3 (Reuters) – The massive rally in Apple’s shares is forcing some fund managers to revisit a thorny dilemma: they may not own enough of the stock.

Apple’s share price has soared 49% so far this year, ballooning its weight in stock indexes to record levels and pushing its market capitalization over USD 3 trillion. The company’s weighting in the S&P 500 has swelled to 7.6%, the biggest of any one stock in the history of the benchmark index, according to S&P Dow Jones Indices.

That hefty weighting means moves in Apple’s shares have an outsized influence on index performance. Yet many investors hold allocations of Apple that are smaller than its relative weighting in indexes, whether it’s due to the desire for portfolio flexibility, worries over owning too much of any one position and limitations imposed by the rules of their own funds.

If shares of Apple keep rallying, that could hurt the results of active fund managers, who strive to beat indexes such as the S&P 500 or Russell 1000.

The issue has taken on additional urgency this year, as the market’s gains are being led primarily by a handful of megacap companies such as Apple, Microsoft (MSFT), and Nvidia (NVDA), whose shares have outperformed.

“If you’re an active manager, one of the issues is it’s hard to own that much of one name. You are taking on more and more risk,” said Todd Sohn, technical strategist at Strategas.

“Because they are such heavy weights within the benchmarks, it becomes really challenging to outperform.”

UNDERALLOCATED

Of 418 US broad market funds tracked by Morningstar, only 26 held a greater weight in Apple than the stock’s weight in the S&P 500, according to their most recent regulatory filings.

The lower allocations to Apple and other stock market winners may be hurting their performance. Only 20% of actively managed mutual funds with broad US market exposure have outperformed the S&P 500 year-to-date as of June 28, according to Robby Greengold, strategist at Morningstar.

Only 6% of active large-growth funds around in 2013 outperformed the category benchmark through 2022, the firm’s data showed.

Greenwood Capital, which has USD 1.4 billion in assets under management, counts Apple as one of its top five holdings, said chief investment officer Walter Todd. But risk management rules at the South Carolina firm prohibit putting more than 5% into any one stock; that means the firm is underweight Apple compared to the S&P 500, to which Greenwood funds benchmark their performance.

The firm likes Apple’s stock fundamentals, so “it’s not that we are rooting for it to go down,” Todd said. “We just think there are other names that have the opportunity to do better.”

The cost of limiting Apple shares may be particularly high for fund managers this year, given the stock’s swelling weight in indexes.

Apple’s weighting in the S&P 500, for example, is bigger than the entire 37-stock consumer staples sector, which was last at a weight of 6.7%.

In the MSCI All-Country index, a widely used benchmark for stocks globally, Apple’s 4.7% weight is greater than that of all United Kingdom stocks combined, which account for 3.6%, according to DataTrek Research.

Some investors are happy to hold hefty positions in the stock.

Alex Morris, chief investment officer of F/m Investments, said its F/m Investments Large Cap Focused Fund holds a 13% weight in Apple, slightly above the weight in the Russell 1000 growth index, which is the fund’s benchmark.

“Fund managers at their own peril don’t hold Apple and a handful of stocks just like it at index weight or about index weight,” Morris said.

Whether Apple can maintain its outperformance remains to be seen.

Apple’s forward price-to-earnings ratio at 29.5 times, is about twice its median P/E over the past decade, according to Refinitiv Datastream. Analysts’ median price target for Apple shares is USD 190, according to Refinitiv data, 2% below the stock’s closing price of USD 193.97 on Friday.

Peter Tuz, president of Chase Investment Counsel, which has about USD 340 million under management, said his firm sold about one-third of its shares this year over concerns about its valuation. The stock is still his firm’s fourth-largest holding, even though at 4% of the portfolio, it puts it underweight Apple versus the S&P 500.

“If you don’t own any and the stock does well, indeed as it has this year, you run the risk of lagging,” Tuz said.

(Reporting by Lewis Krauskopf; Editing by Ira Iosebashvili and Anna Driver)