The dramatic increase in equity market volatility this year has many market watchers pointing out a corresponding rise in stock-to-stock correlations. Marketwatch.com picked up on this notion in a recently published story entitled, “The ‘stock picker’s market’ has gone up in smoke.” After all, if stocks’ returns move together, systematic risk may potentially dominate manager returns; accessing idiosyncratic returns and diversifying risk becomes more challenging. But are rising correlations really happening?
The MarketWatch story points to very sound research showing the spike in correlations as market volatility increased. The article points to the fact that correlations have risen from bottom quartile to top quartile since January, concluding that it’s become a challenging environment for stock pickers.
Of course, Intech® watches correlation trends very closely too. Estimating stock price volatility and correlations relative to a benchmark is a key step in our investment process. The measure of absolute correlation is one of the five metrics comprising the new Intech Equity Market Stress Monitor®. Our measure, however, contradicts the recent articles that suggest a significant increase in correlation. We actually see correlations in the bottom quintile historically, with more idiosyncratic risk in the market.
So is correlation increasing or decreasing?
Actually, both correlation reports can be true at the same time. We just calculate our correlation indicator for a different purpose – understanding stress in equity markets. To do that effectively, our calculation uses a longer time scale and exponential smoothing (and notch filters), which results in marked differences from traditional measures of correlation. Consistent with our overall approach in the new Intech Equity Market Stress Monitor®, we aim to capture secular changes in volatility regimes as opposed to punctual moves that may not persist.
As you can see from Figure 1, our correlation of stock returns measure is far less variable than typical correlation charts that focus on 1-month or 3-month changes in correlations. Perhaps it’s less exciting to watch and it certainly won’t make news headlines, but we find it useful for understanding equity market stress when used with the other metrics in the Intech Equity Market Stress Monitor®. On its own, our correlation metric can be used to quickly identify excessive groupthink when it is either extremely high (late 1980s and late 2000s) or extremely low (mid 1990s and the beginning of 2007) relative to its median.
Figure 1
Correlations of Returns for the S&P 500® Index
Percentile ranks for the period ended March 31, 2018
Looking at the past year trend and relative to a long history, we see correlations across global equity markets at very low levels. Only the future will tell us if the recent increase in short-term correlation constitutes a new trend or if it is just noise in an otherwise relatively stable trend towards lower correlation in equity markets.
Learn more
Appreciating the longer-term trend in correlation is only one element to understanding stress in the equity markets. Used in combination with the other four indicators that comprise the Intech Equity Market Stress Monitor®, you can get a more complete picture of today’s risk environment.
Learn about how Intech® calculates correlation of stock returns and our other indicators of market stress. Download the eBook for the monitor and our quarterly report that interprets last quarter’s observations.
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