Individual stocks are increasingly going their own way. Here's why a selloff might follow.

By Joseph Adinolfi

Implied correlation among S&P 500 stocks hit a record low last week, according to Cboe data

The stock market's "fear gauge" is broadcasting a rosy outlook for the S&P 500. But beneath the surface, individual member stocks are increasingly going their own way.

As a result, six-month implied correlation for S&P 500 SPX members fell to its lowest level on record last week, according to data from Cboe Global Markets - due to the fact that individual member stocks in the index are moving in lockstep much less frequently than they once did.

Implied correlation uses pricing of stock-option contracts to measure investors' expectations for how stocks will move relative to one another in the months ahead. Will they rise and fall together? Or will they move largely independently of one another?

Realized correlation between stocks - that is, the degree to which stocks are actually moving independently of one another - has generally been falling since the bull market began in 2022. That has helped drive implied correlation, which gauges how closely stocks are expected to move together, to record lows.

But the growing divergence between the market's winners and everything else has kicked into high gear since the start of 2024, as a handful of megacap stocks have helped to paper over losses from other names in the benchmark index.

Nowhere is this more obvious than in the returns seen by Nvidia Corp. (NVDA). The company's stock is up nearly 147% since the beginning of the year, making it the second-best performer in the S&P 500 in percentage-point terms. Nvidia's performance has been surpassed only by the much smaller Super Micro Computer Inc. (SMCI), which formally joined the index in March as demand for its servers boomed.

According to analysts at UBS Group, Nvidia alone has contributed more than one-third of the S&P 500's 12.3% advance in 2024. Last week, the chip designer became only the third U.S.-traded company to see its market capitalization top $3 trillion, according to Dow Jones Market Data. On Monday, it completed a 10-for-one stock split.

While Nvidia's gains are extreme, especially for such a large stock, other megacaps have seen substantial gains as well this year. Among the 10 largest companies in the S&P 500, the top performers after Nvidia are Eli Lilly & Co. (LLY) (up 48%), Meta Platforms Inc. (META) (up 41%) and Broadcom Inc. (AVGO) (up 30%), according to FactSet data.

At the same time, 301 companies in the index have seen their shares fall in 2024, according to FactSet data. Nearly 130 of them are down 20% or more, including well-known names like Tesla Inc. (TSLA) - a member of the group of tech stocks known as the Magnificent Seven and currently the 11th-largest stock in the S&P 500 by market value - and Lululemon Athletica Inc. (LULU).

That isn't to say that megacap stocks are the only ones seeing strong returns in 2024. A total of 73 stocks in the S&P 500 are up 20% or more as of Friday's close, according to FactSet.

But even with these included, the percentage of stocks outperforming the index has been notably weak for the second year in a row, according to an analysis from Richard Bernstein Advisors. With the exception of 2023, 2024 is on track to be the year with the fewest S&P 500 stocks outperforming the index since 1999. The S&P 500 was up 12.2% year to date as of Monday afternoon.

See: This viral chart compares today's weak market breadth to peak of dot-com bubble

Dispersion has even shown up within the vaunted artificial-intelligence trade, where it has intensified since the start of the second quarter, according to an analysis from Bespoke Investment Group.

According to Bespoke, AI beneficiaries worth more than $1 trillion were up a combined 11.5% on average since the beginning of April, while shares of smaller stocks benefiting from the trade - including many software names - struggled.

The winners include the six largest U.S. companies by market capitalization: Microsoft Corp. (MSFT), Apple Inc. (AAPL), Nvidia, Alphabet Inc. (GOOG), Amazon.com Inc. (AMZN) and Meta Platforms Inc.

Seeing dispersion increase during a bull market isn't exactly unusual. Typically, the market's winners and losers become more pronounced during a bull run, Jonathan Krinsky, chief technical strategist at BTIG, said in comments emailed to MarketWatch.

But this time around, it is the extreme level of dispersion that has caught Krinsky's attention, and that of other analysts as well. The big question, in their eyes, is when interstock correlation might bounce back, since that would likely coincide with another selloff.

While it is possible that underperforming stocks could catch up to their peers, Krinsky doesn't see this as the most plausible scenario.

"Can the market rise and correlations rise? Possible, but that would probably be like a melt-up scenario where everything rallies together," Krinsky said.

"I think most likely scenario is correlations rise from all-time lows as the market falls," he said. "That's generally what happens."

So far, options traders see few risks on the horizon. They expect stocks - or at least the S&P 500 - to remain calm over the coming month, based on the level of the Cboe Volatility Index VIX, known as the stock market's fear gauge.

The index, which is based on trading activity tied to S&P 500 index options, remained below 13 as of Monday afternoon, according to FactSet. The gauge has risen only modestly since hitting a four-year low in mid-December. It tends to rise as stocks fall, and vice versa.

All three major stock-market indexes along with the small-cap Russell 2000 were trading higher Monday afternoon, with the S&P 500 up 0.2% at 3,355 and the Nasdaq Composite COMP up 0.1% at 17,156. The Dow Jones Industrial Average DJIA, meanwhile, is up 50 points, or 0.1%, at 38,852.

-Joseph Adinolfi

This content was created by MarketWatch, which is operated by Dow Jones & Co. MarketWatch is published independently from Dow Jones Newswires and The Wall Street Journal.

(END) Dow Jones Newswires

06-10-24 1501ET

Copyright (c) 2024 Dow Jones & Company, Inc.