Sector ETF Correlations Highest Since Financial Crisis

by: John Spence

U.S. sector exchange traded funds are moving in lockstep to a degree not seen since the credit crunch in 2008 as markets remain unable to shake fears over Europe’s sovereign debt crisis.

“Average correlations between the 10 major sectors of the S&P 500 have reached 97.2%, from 82.1% just three months ago. That’s the highest level of such common price action since the financial crisis,” writes Nicholas Colas, chief market strategist at ConvergEx Group, in a note Tuesday.

Although precious metals ETFs and investment grade bonds have provided some diversification benefits, the difference between investing in emerging markets equities, developed markets stocks and high yield bonds “is now effectively zero,” Colas wrote. “We think these high correlations will plague markets through the end of the year, since they are fundamentally caused by worries over European financial market solvency. Those aren’t going away anytime soon.”

ETF correlations spiked during the subprime meltdown as global risk assets sold off in unison. There were few safe havens, such as the U.S. dollar and Treasury bonds.

The current correlations observed in industry sector ETFs are “profoundly and dysfunctionally high,” Colas said.

In healthier markets, some stocks and sectors rise, while others fall. But now they’re moving as a herd. “Markets are trying to discount the survival rate of another cross-border financial pandemic. That is why they move in lockstep,” the strategist added.

Elsewhere, high yield bonds are also showing a high correlation with the S&P 500. Investment grade bonds, gold and silver ETFs have moved independently of stocks, helping to diversify portfolios.