August 30, 2023
Correlations play a pivotal yet sometimes overlooked role in predicting future market volatility. The correlation between stocks within a portfolio reflects their tendency to move in tandem. Stocks that exhibit strong positive correlation indicate a lack of diversification, subsequently amplifying portfolio volatility.
In the context of OptionMetrics IvyDB Beta, our focus is on deciphering market expectations for future correlation, known as “implied correlation.” This metric is derived from the implied volatilities of SPY constituents. While implied correlations are essentially pairwise figures between individual stocks, we can gauge an overall “average” correlation across the market by computing the mean across all pairs within the portfolio.
In assessing this information among the leading 50 SPY constituents, we find that as of the conclusion of July 2023, the average implied correlation among the leading 50 SPY constituents hit a five-year nadir, registering at 0.17. Notably, this value falls within the bottom 1% of observations tracked back to 2017. Illustrated in the following graph, this aligns with the broad trend of declining correlations that were set in motion in January 2023. This phenomenon can be attributed to a stratified market environment, wherein the dominant surge, powered by the top 7 mega tech constituents, spearheaded approximately 70% of the 2023 rally.
Nevertheless, it is important to note that the average correlations have since nearly doubled from that point, reaching a current level of 0.32. This discernible fluctuation can be attributed in part to earnings dynamics exhibited during August. Stock correlations tend to rise during earnings periods as earnings disclosures provide investors with insights into sector performance and broader economic trends.
The pivotal question for investors is whether correlations are poised to recede once again, especially with the conclusion of this earnings season. Elevated correlations are indicative of a narrowing performance gap between Mega Cap stocks and their counterparts, i.e., “every other stock.” A rising average correlation translates to synchrony in stock movements, rendering them susceptible to similar market shocks. This scenario sets the stage for a potential upswing in market volatility during the forthcoming fall season.