Correlation will lead to opportunities Stocks have never been so correlated. The specifics of each company's profit and loss account have become secondary to the broader factors of the market. The figures demonstrate this beyond argument. In October last year, for example, the one-month correlation between individual S&P 500 stocks reached 90 per cent. The average since 1990 has been 30 per cent. Similarly, the correlation of different geographical indices has increased steadily. Twenty years ago, emerging markets offered great diversification from the developed world, with a correlation of almost zero. Now, that correlation is close to 80 per cent, according to MSCI indices. Correlations that are this close imply that markets are ignoring corporate fundamentals, and that therefore companies" cost of equity is being set inefficiently. So this matters. But why has correlation grown? That is a hard question because correlation does not necessarily imply causation, let alone the direction of causation. It is not clear whether correlation is a symptom or a cause. There are two broad explanations, which are not mutually exclusive. The first concerns the risks that all companies face. For several years, there has been a significant risk of extreme events, driven by politics. Thus the latest political news from the eurozone shifts the probability of a catastrophic break-up of the euro, and this swamps specific corporate factors. If this is the case, then companies just have to put up with the notion that their cost of equity is largely being driven by the wranglings of politicians. A second explanation concerns the investment management industry. Passive investment was almost unknown until the 1990s, and then grew quickly as the financial engineering behind exchange traded funds was perfected in the 2000s. Options backed by broad indices, rather than stocks, have also flourished. Passive managers do not attempt to spot under or overvalued stocks; they simply buy the index. The more money is managed this way, the more stocks will move in alignment with each other; and the more there is a case for shaking up the investment management industry. A fascinating paper published in June by Goldman Sachs ran the numbers and argued that the first explanation is more important than the second. Circumstantially, higher correlation and greater use of passive management have gone hand in hand. According to Goldman, the assets of passive equity funds in the US have grown 24 per cent a year since 1995, against 8 per cent for active funds. Over that period, passive managers" share of all US equity assets has gone from 5 per cent to about 26 per cent. The growth in ETF trading has swamped trading in individual equities. According to Goldman, the daily trading volumes in the three US ETFs that track the S&P 500 directly are now almost exactly equal to the total trading in all 500 individual stocks that make up the S&P combined. But this could be correlation's symptom, not its cause. As investors grasp that everything depends on politicians, they find it easiest to express their reactions to the latest news using ETFs. And there is also a secular shift at work. Passive investing has grown, driven mainly by cost arguments; correlation has bumped up and down, largely in line with macro concerns. Over time, Goldman found that correlation is itself correlated with macroeconomic and market factors. Equity correlations rise in times of recession and high and rising unemployment. Since the eurozone crisis began in late 2009, European stock correlations have moved in line with moves in the default risk of peripheral sovereign countries. In the US, correlation between stocks is volatile, and spikes at moments of tension - such as the 1997 Asian crisis, the Long-Term Capital Management crisis of 1998, and the invasion of Iraq in 2003. Correlations are highest when the equity risk premium is highest - when stocks are cheapest compared with bonds, an indicator of pessimism. So on that argument, correlation is a byproduct of a lousy economy, high perceptions of risk and low valuations of stocks. It is one of the many side-effects of these conditions that make it harder for capitalism to function effectively. For investment managers, this implies that correlation will reduce once macroeconomic risks decisively recede. So there is an opportunity for skilled stockpickers. For investment banks, Goldman suggests that there is a role for trading correlation, by exploiting differences in the options markets for indices and their component stocks. For corporate treasurers, none of this helps. While risk aversion persists, they will exert even less control than usual over their cost of equity.