By Wallace Witkowski, MarketWatch

Stock correlations have dropped dramatically since election

In true out-with-the-old-in-with-the-new fashion, investors are abandoning their post-financial crisis mentality of panning for yield and cycling into big bets based on what they think a will bring, with an eye on how the Federal Reserve may clash with those policies.

Stocks surged to records Friday and have been on a tear since the surprise presidential election of Donald Trump a month ago, setting new closing records on nearly a daily basis (http://www.marketwatch.com/story/dow-set-to-stretch-out-record-run-with-5th-day-of-gains-2016-12-09). The Dow Jones Industrial Average posted its fifth week of consecutive gains, rallying 3.1%, while the S&P 500 index also gained 3.1% on the week, and the Nasdaq Composite index surged 3.6%. The Russell 2000 index closed at a record with a 5.6% gain on the week.

With the Fed widely expected to raise rates on Tuesday (http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html) following their policy meeting, investors will look for how the central bank couches their expectations for the pace of future rate increases over the coming year, said Nicholas Colas, chief market strategist at Convergex, in an interview.

Other than that, the current rally in stocks is appearing not to be an anomaly as some have suggested, Colas said, but a dramatic shift in thinking on the part of investors, many of whom were caught off guard by the election having been committed to the business-as-usual investing of the past eight years.

"I think the number one thing here is that you have the same party controlling Congress and the presidency," Colas said. "Republicans own the economy for the next two years."

One major trend supporting a broad shift in thinking has been a sudden drop in stock correlations, the strategist noted. Up until the election, sectors were more of less moving in lockstep with the broader S&P 500 on macro events and central bank policy. In other words, the higher the correlation, the more sectors and individual stocks moved in lockstep with one another. That all changed following the election, when investors started taking a hard look at which sectors and individual stocks were the most likely to benefit and be hampered by a Trump administration.

In a note, Colas pointed out that average sector correlations dropped to 56.8% in November, their lowest level since October 2009 when Convegex started tracking the metric. That's down from 66% in October, and 79% in September, meaning investors are becoming more selective in their stock picks.

Read:Stock market's velocity after Trump has investors talking Dow 20,000--and beyond (http://www.marketwatch.com/story/velocity-of-trump-exuberance-has-stock-markets-talking-dow-20000-and-beyond-2016-12-09)

The financial sector was been the biggest winner, with the sector rallying nearly 19% since the election. That sector has also seen one of the biggest drops in correlation to the S&P 500 along with other large correlation drops being in the industrial and energy sectors.

One of the reasons Colas believes this rally has legs is that many investors are playing catch-up in these under-owned sectors, and that takes a while to turn around. Very few portfolio managers have been even-weight or overweight financial stocks since the Great Recession, and weak capital investment and infrastructure spending has had the same effect on the industrials sector.

"It's like you had a bunch of ugly ducklings that suddenly became swans," Colas said.

To pour money into those unloved sectors, investors are selling off overbought positions in darlings like tech and health-care, he said, and that takes time to play out.

Going even past a so-called Santa Claus rally, stocks may climb higher until at least Trump's inauguration on Jan. 20. That's when Trump's first 100 days in office will have to contend with Janet Yellen's Fed, which could create tension for investors. That will be a time for investors to take stock of what's worked and what hasn't and fine-tune their strategy, Colas said.

While Trump has promised policies concerning deregulation and lower taxes, Yellen's Fed still needs to be on watch for a sudden overheating of the economy and rising inflation.

"The Fed could be the hand brake on the economy next year, because if there's stimulus then Fed has to worry about inflation, and there's going to be tension," Colas said.

Read: Fed to hike interest rates next week while ignoring the elephant in the room (http://www.marketwatch.com/story/fed-to-hike-interest-rates-next-week-while-ignoring-the-elephant-in-the-room-2016-12-09)

Then again, with dwindling confidence in the Fed, investors may just come to regard Yellen as a lame-duck Fed chairwoman with her term ending in February 2018, Colas noted.

While earnings season is pretty much over, a few notable companies are set to release results, namely, Oracle Corp.(ORCL) and Adobe Systems Inc.(ADBE) on Thursday.

(END) Dow Jones Newswires

December 10, 2016 08:01 ET (13:01 GMT)