Examining Industry Return Correlations by Lawrence Hamtil

Since the financial crisis, there has been a certain amount of chatter about how important financials in general (and banks in particular), are to the performance of the overall stock market.  This makes sense to a certain extent; after all, as this JP Morgan graphic reveals, since 1990, the financial sector has been a steadily growing weight within the S&P 500:

Industry Return Correlations

Industry Return Correlations

I wanted to take the data back a bit further to see just how correlated the S&P 500’s returns have been with the financial and banking sectors’ returns.  So I ran the numbers using Professor Ken French’s data set.  Here are the results for the banking sector:

Industry Return Correlations

and for other financials, such as money managers:

Industry Return Correlations

From 1974-2015, the S&P 500 returned 10.81%/yr, while banks returned 10.26%/yr, and financials 12.47%/yr.  Obviously, there has been a very high correlation between broader market returns and both the banking and financial sectors.

However, there are other sectors that have had similarly elevated correlations (and arguably just as important correlations) with the overall market:

For example, technology stocks returned about 10%/yr over the same time frame, and the R^2 for technology stock returns and the S&P 500 is above 70%:

Industry Return Correlations

Even though they have a reputation for being “defensive,” Consumer Non-Durables / Staples returned 14.2%/yr since 1973, but returns were actually highly correlated with the S&P 500 with a R^2 of 68%:

Industry Return Correlations

My interest was somewhat piqued by these results, and given that my friend, Isaac Presley, had just written a post about how investors should diversify their industry exposures (among other things), I wanted to test the return correlations for some other industries.

Energy, which has gotten a lot of press this year as oil and stocks were highly correlated, has actually been somewhat of a diversifier as far as returns have gone; annual returns for energy were 11.08%/yr 1974-2015, but correlation of returns was only 43%:

Industry Return Correlations

The results were even more dramatic for both the utilities industry…

Industry Return Correlations

…and especially the tobacco industry:

Industry Return Correlations

Despite a steadily declining weighting within the S&P 500, the utilities sector managed to beat the S&P 500, 11.14%/yr vs 10.81%/yr.  The tobacco industry crushed the S&P 500 with astounding returns of 16.98%/yr.  Both industries did so but with significantly less correlation in returns.

Here is a table summary of the results 1974-2015:

Industry Return Correlations

The takeaway here is that the market is a dynamic organism.  Broad measures of the market such as the S&P 500 have some characteristics of momentum, as Ben Carlson recently pointed out.  Industry weights will shift when oil prices fall and energy firms contract, or when tech bubbles expand and implode, etc.  It is important for investors to ensure that they have broad industry exposure within their portfolios as there will be times when lower-weighted sectors that are out of favor will prove their merit as diversifiers when market dynamics shift yet again.

The information provided above is obtained from publicly available sources and it is believed to be reliable. However, no representation or warranty is made as to its accuracy or completeness.