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The financial crisis provides a good reference point for sector correlations as well, and the data seems to support the commonly held belief that correlations across all assets classes—including between sectors of the equity universe—have spiked. The data also show that this may be changing. Over the past 15 years, sectors have shown extremely low correlations between each other, with an average of 0.50 and a high of 0.85 (industrials and consumer discretionary). Over the past 10 years, it is also low, but the average has crept up to 0.61, with the highest correlation at 0.88. Over the past five years, that average correlation among sectors climbs all the way to 0.68, with eight different sector correlations above 0.85. The past three years had an even higher average correlation among sectors, but in the past year, that figure has dropped back down to 0.62. Clearly, the ability to effectively use low correlation pairs is compromised in times of significant financial stress, but it seems the further removed we get from the financial crisis, the more pronounced the divergence among returns is.
How the various sectors move in relation to each other and to the market is just part of the story. We must also analyze how much volatility each sector has shown historically and whether that has changed over time. As we would expect, the defensive sectors—consumer staples, utilities and healthcare—all showed 20 percent or less annualized volatility over all time frames. On the opposite end are financial and energy firms, which showed volatility in excess of 25 percent over all periods of study. Recent history bears this out. Financials were the hardest-hit sector through the financial crisis of 2008 and the recent European debt crisis. Meanwhile, energy prices spiked in 2007, only to come crashing down to earth before spiking again.
This distribution of risk among the sectors offers even more information to investors attempting to fine-tune their risk exposure in various market environments. The recent wave of high- and low-beta and volatility index strategies is a logical extension of these sector risk profiles. Whereas index providers and ETF issuers are looking to provide new ways to slice the market, for investors focused on risk as opposed to exposure, sectors already allow them to do this.
In all, the intuitive nature of sectors lines up with statistical evidence. Over the past 15 years, with the exception of times of financial stress, sectors have shown all of the necessary characteristics to prove how valuable they are in asset allocation. Their returns vary greatly, their individual performances show economically logical relationships, and they exhibit distinctly different volatility patterns.
The Style Perspective
Investors have long used a value and growth perspective to parse the market in a different way than sectors. The problem is that the line between growth and value is blurry, and the overlap in exposure between high- and low-correlated sectors diminishes the efficacy of this strategy as a way of segmenting the market.
Investors of all sizes have made style-based investing hugely popular over the years. The stereotypical value investor wants to buy stocks that are lower in price or are otherwise out of favor. Value investors might also want to see consistent positive earnings, especially when regularly paid out as dividends. A growth investor is willing to pay a higher relative stock price with the goal of latching on to the next Apple Computer, i.e., a stock with huge price appreciation driven by earnings growth beyond expectations.
Style indexes use a variety of fundamental measures to describe stocks as value or growth oriented. These include price/book, as mentioned above, as well as price/earnings, price/sales and price/cash flow. In addition, indexes often include stock price momentum and various growth rates, using historical and forward-looking estimates.
When stocks are screened by these metrics, results don't always fall into neat buckets that clearly indicate value or growth. Index designers need to decide what to do with muddled results from firms that sit in the middle gray zone between the two extremes. Some indexes choose to split a stock's weight across the value and growth buckets, with the benefit being growth and value indexes that roll up into a complete picture of the market. Other indexes assign the stocks that don't show strong style biases into a separate core bucket, leaving the growth and value indexes with more "pure" components.
These core stocks—those firms that do not show a pronounced growth or value bias based on the aforementioned metrics—muddy the growth and value picture. Because they show characteristics of both growth and value, they end up detracting from the ultimate goal, which is to separate the market into two distinct exposure groups. The removal of these firms should exaggerate the difference between growth and value. The problem is that there is still too much ambiguity and disagreement over what makes a company a growth or value firm.
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