The problem for investors is that correlations typically decline as a bull market matures.
The S&P 500 is on course for its worst month since September 2023, as the Trump tariff turmoil meets fretting about overvalued AI companies to hit investor sentiment.
And there's another reason for concern says Jim Paulsen, the former chief strategist of Wells Fargo's institutional asset management arm. In his Paulsen Perspectives blog, he notes that the correlation between S&P 500 SPX constituents is around a two-decade trough and that "has been associated with periods of low returns for investors."
To understand why this may be so, we need to understand what tends to dive intra-market stock correlations.
Stocks tend to move very closely in tandem at times of stress. The S&P 500 SPX constituent correlation will move closer to 1 when an anxiety spike may see traders move out of the asset class and not distinguish between individual stocks.
However, at other times high correlations can also indicate better market breadth. And supportive fiscal and monetary policy can boost correlation because the whole economy is expected to benefit.
"Investor confidence, market breadth, and policy accommodation all impact the market's average correlation signal. In this sense, it is understandable why low correlations (suggesting investor optimism, diminishing breadth, and policy tightening) historically suggest lower future stock market returns," says Paulsen
As the chart below shows, while not all difficult stock markets have been associated with low correlation, the S&P 500 usually struggles when the correlation among its members is as low as it is today, Paulsen notes.
He further observes that six of the eight bear markets since 1980 have occurred when the intra-correlation was below average, and none have occurred when correlation was in its highest quartile. Moreover, six of the fourteen corrections have started when correlation was in its lowest quartile and three more occurred when it was below average.
"While low correlation does not guarantee stock market turbulence, it certainly raises the odds of potential difficulties," he says.
Source: Paulsen Perspectives
The current correlation is near its lowest in the past 25 years - partly a sign of the low market breadth as driven by outperformance of big tech stocks over recent years. Paulsen also reckons that the correlation has been suppressed by "an unprecedented 16 consecutive months of negative growth in the money supply, a chronic inverted yield curve, and a Fed which has been in contractionary mode throughout almost this entire bull market."
He also argues that the present low correlation among S&P 500 members suggests that investors are much less pessimistic in their actions than recent dour sentiment surveys pretend.
The problem for equity investors is that correlations typically decline as a bull market matures, Paulsen says, and the next chart illustrates the point. It shows the one-month forward average annualized S&P 500 price return for all months since 1980 when the S&P 500 intra-correlation was in its lowest, middle two, and highest quartile ranges.
"The results are quite striking. Since 1980, the S&P 500 has experienced an average annualized future return 2.8 times greater when the market's correlation was in its top quartile (i.e.,16.86%) compared to when the correlation was in its bottom quartile (i.e., 6.04%) as it is today!," he says.
Paulsen stresses that correlation is just one indicator among many investors are currently monitoring including valuation, overall investor sentiment, market momentum, and economic health.
"However, the degree of correlation displayed by the components comprising the stock market has proved to be a good historical indicator of future risk and reward. And currently, the intra-correlation among S&P 500 members is extremely low suggesting investors may face a slog until correlations improve," he concludes.
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