The Risk-On/Risk-Off Trade Just Died

Includes: DIA, QQQ, SPY
by: Lou Basenese

"We've been tracking this data since the financial crisis, waiting for this moment," says Nicholas Colas, chief market strategist at ConvergEx. What "moment" could possibly be so important that it requires a constant vigil? In short, it's the precise instant when the rising tide that's supposed to lift all boats during a bull market, well, doesn't lift all boats anymore.

It's something that I've been tracking closely myself. And it's finally materialized. Want immediate proof? Look no further than the year-to-date performance for the top 25 companies in the S&P 500 Index. It's all over the map.

Apple (NASDAQ:AAPL) is down 3%. Exxon Mobil (NYSE:XOM) is up 3%. Hewlett-Packard (NYSE:HPQ) is up 84%. Coca-Cola (NASDAQ:COKE) is flirting with double-digit appreciation -- now up 8%. Meanwhile, General Electric (NYSE:GE) shareholders have been rewarded with a 14.5% gain. We shouldn't bemoan this development, though. Instead, we should celebrate it. Here's why.

Index Huggers Beware

Ever since the financial crisis hit, all stripes of stocks -- large-cap, small-cap, international and emerging markets, you name it -- have been moving in near lockstep with one another. Heck, until a few days ago, you'd think Apple and Exxon were the same company based on how similar their charts looked.

Most asset classes have been moving in sync, as well. This market dynamic became so widespread that we developed a catchy phrase to describe it: The market has either been in "risk-on" or "risk-off" mode. During risk-on mode, investors sell bonds and pile into stocks, commodities and emerging markets. During risk-off mode, they do the opposite. They bail on all investments in favor of the safety of bonds, particularly U.S. Treasuries.

More technically speaking, we’'ve been witnessing a period of strong correlations between investments -- really strong correlations. As Stacey Williams, head of Foreign Exchange Quantitative Strategy at HSBC, puts it, "When the crisis hit, correlations went to the moon and stayed there." But in recent weeks, something major changed. Correlations completely collapsed. And the evidence is everywhere.

Research from Citigroup shows that rolling one-month correlations between the moves of the top 50 stocks in the S&P 500 plummeted from 66% to 12% at the end of June. Deutsche Bank says that price swings for individual large-cap stocks in the Russell 1000 Index now sport a correlation of just 30% with the overall Index. That's down from nearly 60% only one year ago.

Data from ConvergEx indicates that high-yield bond correlations with U.S. stocks fell to just 16% -- down from a high of 67% over the most recent three-month period. And emerging markets and international stock correlations fell to 58% and 76%, respectively, from a recent high of 80%.

Bespoke Investment Group reveals that the "all or nothing days" -- when at least 400 out of the 500 stocks in the S&P 500 are up or down in price -- pulled a Houdini. They've all but disappeared. There have only been 13 this year, based on Bespoke's last count. That's down from 70 in 2011.

So what does all this mean? Essentially, all the index-huggers -- who plowed more than $2 trillion into exchange-traded funds that passively invest in various indices - are about to get their clocks cleaned. Why? Because we're officially entering into a stock picker's market, whereby individual fundamentals (not the direction of the broader tide) will determine future prices. Or, as Colas recently told CNBC, we're transitioning from a market that rises in unison based on Fed liquidity, to one in which investors are going to start picking "winners and losers on fundamentals."

The smart money has already figured this out, too. Case in point: Credit Suisse's latest survey of hedge fund investor sentiment revealed that one of the most unpopular stock-picking strategies 18 months ago is now one of the most popular. And 60% of respondents plan to allocate fresh capital to long/short hedge funds in the second half of the year.

Bottom line: The risk-on/risk-off trade is officially, well, off. So what's on, exactly? Stock picking. And that means profiting from the bull market just got a bit more complicated for the average investor. Simply buying passively managed index funds won't cut it anymore. Not if racking up maximum profits is the goal.

Instead, investors need to take the time to uncover investments with the strongest fundamentals that are trading at compelling valuations, as they're about to really shine.