July 3, 2018 / 12:01 AM / 3 months ago

RPT-COLUMN-Stocks face rising 'volatility, rotation, correlation' unholy trinity: McGeever

(Repeats column moved on Monday without change to text; the opinions expressed here are those of the author, a columnist for Reuters)

By Jamie McGeever

LONDON, July 2 (Reuters) - Stock market volatility isn't scarily high just yet, but it's picking up. What is more telling is what is happening under the bonnet, where sector rotation, volatility and correlations are rising.

These are potentially ominous signals, especially at this stage of the cycle, with the Fed leading a global withdrawal of liquidity, and the threat of global trade wars growing by the day.

Figures from Chicago Board Options Exchange show that the correlation between the S&P 500's constituent sectors and the headline index are higher this year than last, while volatility has jumped across the board, especially in growth sectors.

On the one hand, higher volatility this year should come as no surprise given the VIX index's dramatic surge in early February. It was short-lived but the rise on Feb. 5, in nominal and percentage terms, was the biggest on record.

But even taking that and the gradual creep back up in recent weeks into account, headline volatility is not taking off just yet. The VIX index of implied volatility has averaged 14.6 percent over the past five years, and on Friday it closed at 15.2 percent.

Yet realised volatility has taken off. The CBOE figures show that realised volatility on the S&P 500 averaged just 8.14 percent last year but more than doubled to 19.95 percent in the first half of this year.

Realised volatility in growth sectors such as technology, consumer discretionary and materials doubled, suggesting investors are beginning to doubt how much longer the expansion, currently the second longest in U.S. history, can continue.

SECTOR ROTATION

Correlations between sectors and the broader index are often stronger when the market is falling than when it is rising. The rationale is diversification is all well and good until you get a market selloff, then everything moves down together.

This is what happened after the "volmageddon" episode in February. But a more gentle drift lower or failure to move higher, which is broadly where the market finds itself right now, is more conducive to sector rotation.

Doug Kass, president of Seabreeze Partners Management, reckons the second half of the year will be characterised by a "two-sided" stock market, with heightened volatility, a greater churn between sectors, and an increasingly divergent range of winning and losing stocks.

"At least for most of the balance of this year and, as we approach the November mid-term elections, volatility and rotation will likely accelerate," Kass wrote. This will demand "opportunistic and unimpassioned" investing.

According to Bank of America Merrill Lynch's latest fund manager poll, investors dumped cyclical stocks in June in favour of defensive plays. The biggest sector reduction was exposure to banks, and the biggest increase was utilities.

Investors also cited the so-called "FAANGs" and "BATs", U.S. and Chinese technology shares, as the most "crowded" trade for the fifth month in a row. Rotation out of this sector in the weeks and months ahead would come as little surprise.

As rotation increases, so does the propensity for stock "dispersion", the difference in individual stocks' returns a versus the broader index.

Ideally, investors want to be overweight stocks and sectors that exceed returns on the headline index, and underweight those that lag. This is more difficult when correlations are rising, so it is a test of the active manager's alpha-generating credentials.

Analysts at UBS believe U.S. stocks are in the early stages of a "multi-year" period of higher volatility and greater dispersion of returns.

"This is the market that active managers have been waiting for since the financial crisis. Time will tell if they deliver," they wrote.

Reporting by Jamie McGeever Editing by Alison Williams

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