Market Correlation: From Record Highs to the Lowest in 25 Years

Hedge funds are breaking out the party hats and placing orders for ice cream cake because it's time to celebrate: Market correlation has instantly gone from one of the highest-ever levels to one of the lowest.

Strong market correlation was a serious nuisance for investors in 2011 because most stocks in the market would essentially move in the exact same way. Firms quickly found that their traditional strategies were failing, diversification was useless, and skills in picking out individual stocks and asset classes essentially counted for nothing. It also meant returns were low, if not in the red.

In fact, the only discernible skill was picking "up days" and "down days," which really all depended on the day's headlines. As Scott Billeadeau of Fifth Third Asset Management had said in an interview with Bloomberg back in September: "Europe is a big macro issue and it's so pervasive that at the top of investors' minds, there's nothing to do with individual companies. I'm just buying stocks or I'm selling stocks, versus buying IBM and selling Hewlett-Packard."

Calming down
It was a mess. But now it's not. So what caused this change?

We can't know for sure, but the change does suggest that market panic has cooled down. The events causing the high correlation (EU debt crisis, low employment, China's potential for a hard landing, etc.) just don't seem as big or as immediate of a threat as before.

Simply, investors appear to be going back to a "normal" trading routine, paying more attention to individual assets and less attention to international headlines.

According to new research published by Oppenheimer's Chief Investment Strategist Brian Belski in a note to clients Monday morning (via Business Insider): The change in correlation "is particularly interesting considering January's strong market performance, which implies that while some stocks had very strong gains, others had very weak gains -- a sharp divergence from performance patterns exhibited toward the end of 2011."

Business section: Investing ideas
Now that correlation is down there's once again high risk involved with high beta-stocks. If you're an investor who prefers to play it safe (risk-adverse) than you probably seek low beta (low-risk) stocks for your portfolio.

With that in mind, we created a list of companies that have very low betas, specifically between 0 and 0.5.

To narrow down and improve the quality of our list, we attempted to seek out companies that appear undervalued (using the levered free cash flow to enterprise value ratio) and are the object of bullish attention from institutional buyers, such as hedge funds.

The "smart money" thinks these potentially undervalued and low risk stocks have more value to cash in. Do you agree? (Click here to access free, interactive tools to analyze these ideas.)

1. ICU Medical (NAS: ICUI) : Engages in the development, manufacture, and sale of disposable medical connection systems for use in vascular therapy applications in the United States and internationally. Beta at 0.49. Net institutional purchases in the current quarter at 513.5K shares, which represents about 4.19% of the company's float of 12.25M shares. Levered free cash flow at $51.80M vs. enterprise value at $491.95M (implies a LFCF/EV ratio at 10.53%).

2. Arch Capital Group (NAS: ACGL) : Provides insurance and reinsurance products worldwide. Beta at 0.48. Net institutional purchases in the current quarter at 4.7M shares, which represents about 3.99% of the company's float of 117.90M shares. Levered free cash flow at $558.13M vs. enterprise value at $4.58B (implies a LFCF/EV ratio at 12.19%).

3. Pain Therapeutics (NAS: PTIE) : Engages in the research and development of novel drugs. Beta at 0.4. Net institutional purchases in the current quarter at 1.5M shares, which represents about 5.65% of the company's float of 26.55M shares. Levered free cash flow at $20.11M vs. enterprise value at $92.16M (implies a LFCF/EV ratio at 21.82%).

Interactive Chart: Press Play to compare changes in analyst ratings over the last two years for the stocks mentioned above. Analyst ratings sourced from Zacks Investment Research.

Disclosure: Kapitall's Rebecca Lipman does not own any of the shares mentioned above. Institutional data sourced from Fidelity, all other data sourced from Finviz.

At the time thisarticle was published The Motley Fool owns shares of International Business Machines. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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