There is a great deal of talk this morning about the large in increase to historically high levels for the Chicago Board Options Exchange S&P 500 Implied Correlation Index.  This measure simply means that investors are betting that stocks will, as has been the case during much of the post-financial crisis, era that stocks will move more in line with each other.  The question is to what degree this matters for investors.

Some of the discussion around implied correlations focuses on the data point that we haven’t seen stocks move together like this since October 1987.  The implication being that the market is poised for a waterfall decline.  It isn’t clear that there is any sort of systematic relationship between implied correlations and forward returns.  In short, if the market wants to decline further it does not need permission from this index.

For those interested in doing a deeper dive into the construction of this measure then check out a post by Steven Place who does a nice job of explaining what exactly is the implied correlation index and the implications for traders.  Below is a graph he shows including the recent, rapid rise in implied correlations:

Mark Hulbert notes two reasons why the rise in correlations should not be so frightening.  The first is that whenever volatility is heightened we tend to see higher correlations.  Hulbert writes:

It turns out that increased market volatility more or less automatically leads to heightened estimates of stocks’ correlation—even when nothing has really changed.

In addition it has been known for some time that in bear markets correlations increase.  The question for investors is whether the market’s structure has changed all that much.

In a certain respect it doesn’t matter.  Portfolio managers are charged with generating abnormal returns in all manner of market environments.  Today’s environment is characterized by high volatility and high correlations.  A manager, or his investors, can always choose not to play the game.  However you can’t play the game AND choose to use high correlations as an excuse for poor performance.

Items mentioned above:

Stock correlations are soaring.  (Crossing Wall Street)

What is the implied correlation index?  (Investing With Options)

A stock market vs. a market of stocks.  (Mark Hulbert)

The (great) correlation cop-out.  (Abnormal Returns)

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