How To Identify A Stock-Picker's Market

After several long years of risk-on/risk-off markets -- during which everything acted like the S&P 500 and adding alpha was difficult -- it appears that stock-picking is back in a big way.

The natural question, of course, is why?

Before we get to the answer, it is first important to understand that we're not talking about closet-index stock funds, or institutional strategies whose goal is to outperform the benchmark by a point or two. Remember, the fortunes of generic, plain-vanilla growth funds and the like simply rise and fall with the overall market.

No, we're talking about alpha here. We're talking about stock selection strategies designed to outperform the major indices by a hefty margin. Unfortunately, though, these types of strategies had been out of favor for some time. And now they are back. Thus, the question becomes: what causes alpha-driven strategies to suddenly start working again?

What is Alpha, Anyway?

For the statistically-challenged (a camp I find myself in all too often when talking to my quant buddies), let's first spend a moment explaining the concept of alpha. This is not a reference to an alpha male or the leader of the pack. No, in financial parlance, alpha is the amount of return that can be attributed to the skill of a manager or strategy over and above the return of the market itself.

Keep in mind that the stock market goes up the vast majority of the time. And on average, the S&P 500 returns an investor somewhere in the vicinity of eight or nine percent per year. It's the amount of return above what the market hands you on a platter, that we're talking about here.

For example, the S&P 500 gained 29.6 percent in 2013. So, any return above that is the "alpha" your strategy provided.

Got Alpha?

For most stock market investors, the goal is obviously to utilize an investment strategy that adds serious alpha. Otherwise, simply buying the SPDR (NYSE:SPY) will provide you with the return of the overall market, which is easy and cheap.

The problem is that alpha-driven stock selection strategies go in and out of favor. Sometimes they work great and sometimes not. Again, the question is, why?

Correlations are the Key

According to Investopedia, correlation is computed into what is known as the correlation coefficient, which ranges between -1 and +1. Perfect positive correlation (a correlation co-efficient of +1) implies that as one security moves, either up or down, the other security will move in lockstep in the same direction. Alternatively, perfect negative correlation means that, if one security moves in either direction, the security that is perfectly negatively correlated will move in the opposite direction. If the correlation is 0, the movements of the securities are said to have no correlation; they are completely random.

For our purposes, we are talking about the correlations of stocks to the S&P 500. When correlations are high, the vast majority of stocks act like the S&P. And when correlations are low, stocks tend to go their own ways. And this, dear readers, is the key to being able to identify when your alpha-driven strategy is going to be effective.

During a market crisis, the correlation of stocks to the S&P is generally quite high, as traders play the risk-on/risk-off game. In short, during a crisis, everything acts like the S&P and correlations approach +1.0.

Correlations Have Fallen

According to Barclays, the daily fluctuation between the 50 largest stocks in the S&P 500 and the index itself over a 3-month period recently reached the lowest level since 2007. The bottom line is this a good thing for stock pickers and anyone trying to find alpha via stock selection.

If we look at the median rolling 1-day correlations of S&P 500 stocks to the index over a 63-day period (3 months) from 2008 through 2012, the range of stock correlations was between about 0.50 and 0.85. And the vast majority of the time, the correlations during that time were between 0.60 and 0.80, which is VERY high on a historical basis.

For reference purposes, from 1972 through 1986 the range of rolling 63-day correlations was between 0.30 and 0.55. And from 1988 until 2008, the rolling 63-day correlation exceeded 0.60 only three times.

If we look at 126-day rolling correlations, from 1973 to 1987, the high end of the range exceeded 0.50 only three times and never exceeded 0.60 until 2002. However, the low end of the range from 2007 through 2011 was 0.60 while highs above 0.75 were seen three times.

The good news is that in 2013, the range of 126-day correlations fell dramatically, staying between 0.55 and 0.65.

Alpha is Back

Cutting through all the numbers, the key is to recognize that, when correlations fall, the opportunity to add alpha via selection goes up.

So with correlations at their lowest levels in years, stock selection is back. Industry and sub-industry allocation is back. Sector selection strategies are back. Simply put, alpha is back.

So, if you utilize a stock selection strategy, it is important to keep an eye on those correlations. In sum, if correlations start to spike, it means your alpha strategy may begin to suffer. But as long as the correlations stay low, it's a stock-picker's market.