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Of course, every sector is affected by different economic indicators, but there is also significant overlap. Properly defined sectors should therefore show high intersector correlation between segments of the economy whose economic exposures are similar. For example, energy and basic materials are highly dependent on global GDP rates, construction spending, and mining activity. We would therefore expect the two sectors to behave similarly. This is exactly what we have seen, as the intercorrelation between the two sectors did not drop below 70 percent in any of the periods of study and was as high as 91 percent over the past year. These correlation groupings provide an outlet for investors to express their opinion about the economy and the markets. But these relationships are dynamic. One way to show this is by charting the correlations on a rolling basis, as shown in Figures 6a and 6b.
As the market and economy have ebbed and flowed, so has the correlation between technology and the rest of the market. This tells a story about the market and the economy. Negative correlations do not persist over time, but on a rolling basis, different sectors will show negative correlations with each other. These occurrences, while fleeting, are immensely valuable to investors as they allow for true risk diversification. At the height of the tech bubble, technology actually had negative correlations to energy and materials firms, and during the subsequent market sell-off, its correlation to all sectors normalized.
This underscores a common theme in the period of study: During times of market stress, correlations all converge to 1. While this impairs an investor's ability to diversify away market risk during these periods, it is also a predictive piece of information for investors. Further, these correlation convergences do not persist over time, moving away from 1 as a crisis abates. Looking at Figure 7, we see that during the 2008-2009 financial crisis, the performance correlation of all sectors spiked to 1 but normalized as the economy moved out of the recession.
Even when we measure sectors individually against the market—in this case, the S&P 500—we see a wide range of correlations. And just as with intersector correlations, each sector's relationship with the market changes over time. Over long horizons, each sector has a lower correlation to the market, which is logical. Since the S&P 500 is a roll-up of the firms in each sector, the changes in the importance and influence of each sector over time is represented by changes in each sector's weighting in the index. When a sector like energy becomes an increasingly significant portion of the market, it follows that it will have an increasing correlation to the broad market. Between 1998 and 1999, technology went from 17.7 percent of the S&P 500 all the way up to 29 percent before falling to 14.3 percent two years later. This coincided with a steep rise and fall in its correlation to the market.
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