The correlation between the movement of big US stocks is at the highest level since Black Monday in 1987, with price moves increasingly driven by the ebb and flow of investors’ fears over the economic environment.
Stocks, in theory, should move in individual directions based on company fundamentals. But markets of late have been characterised by mass selling alternating with waves of buying, as investors upgrade or downgrade the risk of the US slipping into recession, or a financial crisis sparked by a European sovereign default.
The correlation between the biggest 250 stocks in the S&P 500 over the past month has reached its highest since 1987 this week, at 81 per cent, according to JPMorgan figures.
This means those stocks move in the same direction 81 per cent of the time. The historical average is 30 per cent. The measure peaked at 88 per cent during the October 1987 US crash, when the Dow Jones Industrial Average fell 22 per cent in one session.
Other spikes in correlation, including the collapse of Lehman and the Japanese earthquake, peaked at about 70 per cent but quickly fell away.
The unusually high level of correlation this month has raised speculation that markets could repeat the aftermath in 1987, when relationships between stocks did not return to their historical norm until several months later, in March 1988.
That was thought to be a freak event,” said Marko Kolanovic, head of derivatives strategy at JPMorgan.
The extreme correlation might drive additional trading en masse, said Dean Curnutt, president of Macro Risk Advisors. Traders might be forced to cut positions due to rising volatility in indices such as the S&P 500, a result of their member stocks moving in one direction.
“There’s a circularity that is sustaining correlation and volatility,” he said. “By mandate, many traders have to pare back their positions when high volatility means they are exceeding their value-at-risk limits. That pushes correlation higher.”
The CBOE Volatility Index, the barometer known as the Vix that is a gauge of fears of turbulence, has stayed above 30 in every session since early August. That is the longest such stretch since early 2009, when the market was plunging to its post-crisis bottom.
Marko Kolanovic, head of derivatives strategy at JPMorgan, said correlations might still decline, due to trading algorithms and high-speed trading strategies that react to such unusual moves.
Sustained volatility could have an impact on capital markets. Groupon and Zynga, two highly anticipated social networking IPOs, have postponed offerings this month due to volatility, according to people familiar with their thinking.
Derivatives strategists at Goldman Sachs, in a recent note, said: “While we expect that the correlation level will remain generally high in the market, we would expect reduced correlation as we enter the third quarter earnings season in October and investors refocus on company fundamentals.”
Sustained volatility could have an impact on capital markets. Already, Groupon and Zynga, two highly anticipated social networking IPOs, have postponed offerings this month due to market volatility, according to people familiar with their thinking.
“When the Vix is high it’s hard to launch an IPO,” said Craig Orchant, partner at EA Markets, a capital markets advisory. “IPOs need a long runway, and right now investors don’t think the rain is going to stop any time soon.”
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