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.”

‘Better mousetrap’

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.

In mid-September of 2011, Colas at ConvergEx reported that U.S. sector ETFs were moving in lockstep to a degree not seen since the 2008 credit meltdown. Average correlations between the 10 major sectors of the S&P 500 zoomed to 97.2% from 82.1% three months earlier. [Sector ETF Correlations Highest Since Financial Crisis]

On Tuesday, the strategist proposed a potential “better mousetrap” than the VIX to measure market sentiment: correlations between S&P 500 sector ETFs and the index as a whole.

The VIX has been moving lower lately but sector ETF correlations have been rising. Even with Monday’s spike, the VIX is trading around 20, its long-term average.

“Conversely, the correlation data is sending up a very visible warning flare about future market direction. Back in February/March 2012, this indicator hit its low (good for stocks, since they are moving distinctly and separately) and began to trend higher (bad for stocks). Now, sector price correlations have essentially gotten back to their 2 years averages – 87/88%,” Colas wrote. “The real ‘Buy signal’ from sector correlations is when then hit 95%, some ways from here … this occurred in mid 2010 and Fall 2011 – both good times to buy U.S. stocks.”

However, there are asset classes that “aren’t clustering around stocks like scared sheep in a thunderstorm,” the strategist added. “Precious metals, for all their whippy action this past month, are fulfilling their promise to act independently of financial assets.”

Meanwhile, U.S. high yield bonds are “at the other end of the spectrum” and showing a high degree of correlation with domestic stocks. International equities – developed and emerging economies alike – are also moving in step with the S&P 500, Colas said.

The opinions and forecasts expressed herein are solely those of John Spence, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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