A One-Way Market Foils Stock Pickers as Fed Trounces Everything

(Bloomberg) — Stock pickers who successfully navigated the 2022 bear market are having a harder time making it through the 2023 faltering recovery.

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First, an unexpected risk-on rally in January caught some defensively positioned mutual funds off-guard. Then, stocks started falling pretty much in unison on renewed anxiety about how far the Federal Reserve will go with its rate hikes, ruining efforts to find some way to come out ahead. And as long this one-way wave lasts, equities traders will find few opportunities to make money.

Consider that the correlation between the movement of growth and value stocks has jumped to the highest level since at least 2005, data compiled by 22V Research show. How are stock pickers supposed to find market dislocations when value and growth are doing the same thing?

What’s more, the trend seems unlikely to change: A gauge that measures how in sync stocks are expected to move in the future relative to the past has jumped to nearly a one-year high.

To Michael O’Rourke, chief market strategist at JonesTrading, S&P 500 stocks will continue to move in closer lockstep until the market is done pricing in the prospect that the Fed will raise its benchmark rate as high as 5.5%. The repricing got underway this week. In the swaps market, traders are now pricing in a 25 basis-point rate hike at each of the next three Fed meetings, which would push it to a range of 5.25%-5.5%.

The S&P 500 responded by falling 1.1% on Friday and posting its worst week since December. But the full reaction will likely come with a lag, according to O’Rourke.

“When the dispersion among the S&P 500 members emerges all depends on how quickly it takes for the majority of market participants to realize” that rates are staying higher for longer, he said. “What we are seeing today is the market finally acknowledging that there is no ‘policy pivot’ on the horizon.”

Challenging Conditions

The fact that the market is back to being driven almost entirely by speculation about the Fed’s path is vexing for active fund managers who seek to outperform the broader indexes. Only 29% of the core mutual funds tracked by Bank of America Corp. beat their benchmarks in January. That’s a stark contrast from 2022, when the orderly selloff allowed 61% of them do it.

Conditions may only get more challenging from here. A gauge of implied correlation among S&P 500 stocks over the next 30 days rose to 0.5, compared with 0.3 for a similar gauge of the actual realized correlation. A reading of 1 means securities are moving in sync. The gap between the actual and expected correlations is the highest since early March 2022, when the war in Ukraine and the Fed’s hawkish shift sent markets into a unified drop, data compiled by Bloomberg show.

A similar picture emerges from the performance of value stocks — like trucks and equipment manufacturers that often trade at a discount to fundamentals — relative to growth companies with high valuations. The correlations between the two turned positive recently and went on to hit the highest since 2005, data compiled by 22V Research show.

“That leaves forward returns for value and growth more likely to move together near-term,” Dennis DeBusschere, founder of 22V Research, said in a note.

Read: Global Passive Equity Funds Set to Take Crown From Active

The good news is the more correlations rise, the more room there is for them to break down once the market finally prices in the Fed’s expected path, according to both DeBusschere and O’Rourke. When that happens, the market will again focus on which sectors will fare best as the tighter monetary policy keeps rippling through the economy.

“It may take some time, but once the interest rate-related uncertainty settles, it will be a stock pickers’ environment again,” said Michael Purves, founder of Tallbacken Capital Advisors. “But it’s not going to be easy for anyone.”