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Is Market Correlation Hiding Movement?



September 1, 2017

One of the reasons cited for declining broader market volatility this year has been the sharp drop in equity correlation. But what exactly does “correlation” mean when it comes to the stock market?

Let me provide a simplified, hypothetical illustration: Suppose that an index that is made up of only two stocks: Amazon and Google in equal weights (“the Index”). Let’s say that in one month, AMZN goes up 5% and GOOG goes down 5%. From an individual stock standpoint, those are big moves, but as far as the Index is concerned, nothing happened. AMZN went up and GOOG went down, but the net effect for that Index was zero as both moves cancel each other out. In the investment world, we call this dispersion – the tendency for individual names to scatter up and down in performance.

So when we occasionally see equity markets that are exhibiting a low level of broader volatility (as we have been recently), we should look to see what is happening beneath the surface for a fuller picture. What we’ve been seeing is a great deal of inter-sector movement. Stocks are moving, but in a fashion that is netting out to less broader market movement as far as the indices are concerned.  This is also translating into a lower VIX, which reflects mostly broader option pricing for the S&P500.

There has been a great deal of re-positioning between sectors following the U.S. election, and this has contributed to a ‘dampening’ of overall volatility. Until market correlation begins to rise (meaning equities start to move together somewhat more), we should expect this low volatility index environment and lower VIX to persist. Being aware of correlation can help you to form a better understanding of where movement might be ‘hiding’.

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.

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