Many of the portfolio management models advocate diversification of risks. The goal is to optimize expected returns in a portfolio against specified level of risk. Although knowing the correlations between individual stocks in an equity portfolio is helpful, it cannot predict returns in the stock market for individual stocks. Rather, correlation analysis can only predict the extent to which a stock will move in relationship to a benchmark index (i.e., SPX). This will help to mitigate risk in the construction of an equity portfolio.
Correlation analysis basically allows you to see how well each of the securities in your portfolio move against a benchmark index. This will help to quantify securities within a portfolio from low to high correlation against an index. Correlation coefficient values range from -1 to 1. A correlation between -1 and 0 indicates a negative correlation to the index. This means that the stocks have historically moved in the opposite direction of the index. A value of -1 indicates a perfect negative correlation or have historically moved in the exact opposite direction to the index. Values between 0 and 1, on the other hand, indicates a positive correlation to the index or will move in the same general direction. A value of 1 implies a perfect positive correlation to the index as the security in question will move exactly in the same general direction as the underlining index.
Quant trading outfits, high frequency trading, program trading desks, market neutral statistical arbitrage strategy, hedge funds, pairs trading and computerized driven investors rely heavily on correlation, co-integration, and statistical analysis to help structure their trades and portfolios.
With the rapid growth of index-based funds and passive ETFs we suspect this have skewed the flow of funds in the direction of very large market capitalization stocks and indirectly to individual stocks that may have a high degree of correlation to a benchmark index (S&P 500 Index - SPY and NASDAQ 100 Index - QQQ). Since it has become increasingly difficult to beat benchmarks over the past few years this trend will likely accelerate and sustain into 2020 and beyond.
With the above in mind, we believe it will become increasing important for retail investors to recognize correlation analysis is an useful analytical tool to assist with portfolio construction, risk mitigation, and most important, to help monitor individual stocks that are rapidly moving up or down the correlation scale.
Enclosed below are 2-year correlation studies of the 11 S&P 500 sectors as well as the individual S&P 500 stocks within each of the S&P 500 sectors ranked by high to low correlations against SPX.
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