Worrywarts on Wall Street have gone into hiding.
As the S&P 500 flirts with record highs and volatility cruises closer to historic lows, an overlooked gauge of stock-market fear is flashing a bullish signal: shares are swinging together less and less.
Implied correlation between the 50 largest members of the S&P 500 is near the lowest in at least ten months. Three-month realized fluctuations have fallen back to January levels, while a one-month metric is at its bottom tenth percentile since 2012.
Investors are slicing and dicing equities guided by their micro features, from corporate earnings to regulation, while tuning out headline noise generated by gyrations in global trade, government bonds and emerging markets.
“When everything is good, realized correlation tends to fade, people are rotating into and out of stocks and sectors,” says Michael Purves, chief global strategist at Weeden & Co. LP. “Correlation would travel higher with volatility spikes when people throw the baby out with the bath water -- they don’t discriminate.”
Expectations in options markets that stocks won’t stage in-tandem moves anytime soon means investors may be caught off-guard by a reversal in sentiment.
“Low correlation among index constituents is a late-cycle sign,” says Yannis Couletsis, director at volatility hedge fund Credence Capital Management Ltd., who expects bets on falling stock links to remain profitable through 2019 or 2020.
“Markets don’t just crash from their all-time highs, they gradually weaken first. This translates to individual names or sectors not all performing similarly during the latest phase of a market rally.”
Relentless Rotation
The rotation of capital amid periodic weaknesses among sectors -- from tech stocks, banks to small caps -- continues to fuel this year’s rally, capping index correlations and volatility, in a replay of 2017’s bullish dynamics.
Optimists find plenty of reasons for cheer.