The CBOE Volatility Index, or VIX, is known as Wall Street’s fear gauge. However, ETF correlations may be a better tool for measuring risk because sectors and asset classes moving in lockstep is a sign of a troubled market, according to a ConvergEx Group strategist.
“In terms of assessing market health, a decline in correlation is a positive for markets since it shows investors are focused on individual sector and stock fundamentals instead of a macro ‘Do or die’ concerns,” writes Nicholas Colas in a ConvergEx note Tuesday. “By that measure, we’re moving in the wrong direction, and not just because of recent decline in risk assets.”
For example, ETF correlations spiked in July 2011 before the market actually sold off. [Sector ETF Correlations Surge]
Colas said his monthly review of asset price correlations shows that the convergence typical of “risk-off” periods in the market is solidly underway.
“Average S&P 500 industry correlations relative to the index as a whole are up to 88% from a low of 75% back in February,” the strategist wrote.
“Moreover, other asset classes such as U.S. High Yield corporate bonds, foreign stocks (both emerging market and develop economies), and even some currencies are increasingly moving in lockstep,” he added. “We would highlight that average sector correlations have done a better job in 2012 of warning investors about upcoming turbulence than the closely-watched CBOE VIX Index. Those investors looking for reliable ‘Buy at a bottom’ indicators should add this metric to their investment toolbox.”
Last summer’s dramatic sell-off provides an interesting test of the theory. U.S. stocks fell hard in late July and early August on Eurozone debt concerns. After some choppy action, the S&P 500 bottomed out at 1074 on Oct. 4.