A calm ocean can hide strong currents and powerful tides. In the same way, equity markets have been relatively stable so far in 2017, but under the surface, significant shifts are occurring.
These movements could indicate that investors are returning to stock-level differentiation as the macroeconomic worries of the post-crisis period fade.
Certainly, investors have enjoyed significant returns from the equity markets since the end of the global financial crisis. The post-crisis period has also been marked by elevated levels of correlation within equities, with the stocks of different companies bouncing around together.
At the same time, investors were swinging between hope that the recovery was progressing well and fear that a relapse was around the corner. This 'risk-on, risk off' behaviour has characterised the investing landscape for so long that one could be forgiven for assuming it had become a permanent feature – until a few months ago.
Moving stocks
Throughout the second half of last year, stocks started to move more independently of one another, and the dispersion of sector returns (how differently each sector performs relative to the others) has risen.
This phenomenon has primarily been driven by certain sectors surging higher: financials (as interest rates rose and hopes of deregulation in the US grew) and energy and materials stocks (as commodity prices continued to recover).
These sector movements also helped explain the outperformance of value vs growth in the second half of 2016. In Europe, for example, financials currently represent 36 per cent of the MSCI Value Index, but less than 4 per cent of the MSCI Growth Index, while energy accounts for 14 per cent of the Value Index and less than 1 per cent of the Growth Index (as at 31 March 2017).
Counterintuitively, all this movement within stock markets has led to a period of notable calm at the index level. On average, the first quarter of a year sees 18 days in which the S&P 500 moves up or down by more than 1 per cent; the same period this year saw only two days on which such movements occurred.
Jury still out on correlations
The jury is still out on whether correlations between stocks have truly transitioned from their elevated post-crisis levels. The big sector movements have been crucial in the correlation breakdown we have witnessed and, as the surge in those sectors abates, correlations may rise again.
However, if correlations remain low, we may have entered a new investing regime in which investors are less concerned about macroeconomic instability and more interested in company-specific factors when choosing investments.
As markets have already delivered impressive returns to investors this cycle, the coming years may be more about generating alpha within stock indices, rather than riding the market as a whole higher.
If current conditions persist, the opportunity for active stock selection would appear to be better than in recent years, potentially boosting the probability of outperformance by skilled managers. Value stocks and cyclical sectors would likely outperform in that scenario.
In addition, if the willingness to differentiate between stocks reflects a greater confidence in the resilience of the global economic cycle, then more flows into equities may soon follow, injecting further dynamism into the market rally. If things play out that way, then growth stocks, which investors tend to buy when growth is scarce, would likely underperform.
For now, investors might benefit from keeping an eye not only on top-level market performance, but on the currents that lie below the surface.
Nandini Ramakrishnan is global market strategist of JP Morgan Asset Management
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