The correlation between stocks and the S&P 500 has reached a 20-year high of 0.73, up from 0.44 in July—posing a real challenge for individual fund managers, according to Goldman Sachs.

“Record high S&P 500 and sector correlation poses a challenge for fundamental investors,” said Goldman Chief U.S. Investment Strategist David Kostin. “Elevated correlation is generally considered a poor environment for long-only fundamental investors. In highly correlated sell-offs, the market does not discriminate based on company fundamentals, reducing the value of stock picking.

Investors have been panic selling out of stocks for a number of reasons, Kostin said, citing the downgrade of the U.S. sovereign debt, the ongoing European debt crisis, and indications that the Fed will keep interest rates low until mid-2013.

Goldman also noted that the ability to go short has enabled hedge funds to post average year-to-date returns of just -1%, compared to the average -11% loss for large-cap mutual funds.

Likewise, Credit Suisse measures the correlation of stocks in the S&P 500, and said this reached 80% in August, notably higher than the previous 73% peak reached in late 2008.

Credit Suisse also notes the better performance of hedge funds, attributing much of their success to the ability to stockpile cash; in August, many hedge funds moved as much as 90% of their assets into cash, according to the firm.

As to the reason for the high correlation, Barclays Capital attributes it to the weak outlook for the U.S. economy and the decline in structured products tied to stock options. These structured products, which were popular before the credit crisis cast them in a poor light, created a broader, more liquid market, according to Michael Schmanske, head of U.S. index volatility trading at Barclays Capital. Schmanske believes that correlation could remain higher for a number of years.

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