Declining Correlations Bring Stock-Picking to the Fore

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. We've seen some big change in correlations between markets and sectors in the first part of 2013. I'm here with the global director of equity research, Heather Brilliant, to see what this means for stock investors.

Heather, thanks for joining me.

Heather Brilliant: Thanks for having me, Jeremy.

Glaser: So, first off, why should we care about correlations? Why should the average investor worry about how U.S. stocks are behaving versus, say, European stocks or Chinese stocks?

Brilliant: Well, first of all, when correlations are high, it doesn't really matter which asset class you participate in or whether you pick the right stock, because everything moves in tandem, and so getting the overall macro picture is what really matters. But when correlations are lower, then individual stock selection matters more, individual asset selection matters more, and so for those of us who really are passionate about picking individual companies and finding those great investment opportunities, you can finally start to see the reward of that effort when correlations are lower.

Glaser: So, let's take a quick look back. In the crisis, everyone said correlations basically went to 1, that all markets really were moving in that lock step. Why did that happen and why did that persist for so long?

Brilliant: Yeah. Well, I think there's a couple of primary reasons. First of all, when the macro environment is really the key driver, then correlations tend to go higher. I think that makes a lot of logical sense and we certainly saw it in the financial crisis. So, when the most important thing going on was what's going on with the global banks and whether we're going to be bailing them out, and everything that happened in the financial crisis, that was really the only thing that determined where asset prices were going to go, whether you're talking about stocks, bonds, et cetera.

I think, generally speaking, another factor that really influences a high correlation recently is that there's been a huge increase in the amount of passive investment. You see the rise of ETFs over the last five to seven years has been tremendous, and a lot more passive investment has been going on through ETFs and through other vehicles. So that all means that people aren't picking stocks as much anymore. They're just buying indexes and buying overall passive strategies that can give them exposure to different sectors or markets.

<TRANSCRIPT>

Glaser: What's changed in the last couple of weeks that has really lowered correlation so much?

Brilliant: Well, over the last couple of weeks, we have seen the correlations come down a little bit, but I wouldn't want to extrapolate it as a huge trend yet--it's literally the data from January only. But we try to take a look at the correlation between some of the ETFs of different markets to try to get a sense for how things are trading, and overall, it seems like correlation is really starting to decline. We've seen a couple of other places write about and talk about this trend as well.

So, I do think on the margin, you're starting to see stock-picking matter a little bit more. We're really seeing this in particular in other markets outside the U.S. The correlations between emerging markets, Asia Pacific, and to some extent Europe have become less correlated with the returns for the U.S. market. But overall, you still see the sectors, the different sectors within the U.S., still pretty correlated with the overall market.

Glaser: So, what do we think is driving this? Is it a decline in worries about macro issues? What do you think is behind the decrease?

Brilliant: Well, generally I would say, I think that it's becoming less important to get the macro picture right. And as soon as macro concerns start to fade away a little bit or become more of a neutral globally, then I think you can start picking individual markets that you think will do well, individual investments that will do well in different environments, and you start to see the environments differ too. Right now, I think we're seeing some improvement in the U.S. economy; you're not seeing that to the same extent in Europe. We probably will start to see that, when we get a little bit farther on into the year, but the correlation between the economies is decoupling a little bit too.

Glaser: So given that, where should stock investors be looking? What are the asset classes, what are the types of stocks that we'd expect to do well in the coming years?

Brilliant: Well, we always encourage investors to focus on high-quality, wide-moat investments. Right now, wide moat is pretty much fairly valued. So, there's not a whole lot of opportunity. That said, there are certainly some stocks that are trading at discounts to what we think they're worth. And our research has shown that just buying wide-moat companies is not a recipe for a success; buying wide-moat companies when they're trading at a discount to fair value is really what leads to excess returns over time.

Glaser: Heather, thanks for talking with me today.

Brilliant: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser.