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End of Stock Picking? Don't Try to Beat an Index

By John Melloy, CNBC Executive Producer, Fast Money & Strategy Session

NEW YORK ( CNBC) -- The correlation of moves in individual stocks and the S&P 500 index is at a record, making the job of long-only mutual fund managers to differentiate from the benchmark virtually impossible, according to a report from Goldman Sachs.

The correlation for the S&P 500 and its members is at 0.73, according to Goldman, meaning that the majority of stocks move in lockstep with the index on a daily basis. This is at least the highest in 20 years and therefore likely a record.

"Record high S&P 500 and sector correlation poses a challenge for fundamental investors," said David Kostin, chief U.S. investment strategist at Goldman Sachs, in a Friday note from the Wall Street firm.

"Elevated correlation is generally considered a poor environment for long-only fundamental investors. In highly correlated sell-offs the market does not discriminate based on company fundamentals, reducing the value of stock picking," Kostin said.
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This correlation is up from a statistically insignificant 0.44 correlation before this tumultuous August. The downgrade of U.S sovereign debt by Standard & Poor's after a protracted debt ceiling fight, followed by a rekindling of the Euro crisis and comments from Federal Reserve Chief Ben Bernanke to keep interest rates near zero until mid-2013 created a risk-off, herd mentality. The S&P 500 is down 9% so far this month.

With their ability to go short during the most recent stock market selloff, hedge funds have cut their losses on the year to just 1% on average, according to Goldman. Meanwhile, the average large-cap core mutual fund is down 11% in 2011. No wonder, considering the pressure on mutual fund managers to stay fully invested so as not to miss any rally in the benchmark. The cash-to-assets ratio for mutual funds is at a record low of 3.4%, according to the Crosscurrents market newsletter.

Kostin and other traders believe this lemming behavior among individual stocks could be attributed to the popularity of exchange-traded funds, which allow investors to trade whole indexes and sectors as easily as individual stocks, and the surge in lightening fast high-frequency trading, the buying and selling of millions of stocks in milliseconds based on algorithmic models.

Assets in ETFs have topped $1 trillion this year. Some market analysts estimate computer trading has accounted for 70% or more of the market volume as of late.

"While it is difficult to specify a cause for higher correlation, a spike in S&P futures and ETF trading volumes and parallel reduction in open interest held by institutional and levered funds as reported by the Commodities and Futures Trading Corporation (CFTC) indicate significant de-risking in August," wrote Kostin.

To be sure, this record correlation could open up an opportunity for astute stock pickers if it breaks apart, leaving those that bought the right stocks during this period an opportunity to be rewarded when their individual fundamental stories become recognized. Of course, that's assuming this herd behavior ends.
By John Melloy, CNBC Executive Producer, Fast Money & Strategy Session
CNBC is a world leader in business news, providing real-time financial market coverage and business information.

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