Why such high correlations in Europe, and such dramatic gains in VIX? The answer is twofold.
- August is typically a quiet month. When something “happens”, it tends to dominate. The only other major market to record a monthly stock-to-stock correlation in the 80’s was the U.S. S&P 500 during August 2011 (at that time, the failure to agree the budget threatened a technical default on U.S. Treasuries).
- There still remains very little dispersion. The world’s equity markets have been feeding on vast amounts of global, fiscal stimulus. Our limited historical data suggests that such environments result in very little distinction between the performances of different stocks. When every stock follows the same story, dispersion falls. The impact of this is there is less diversification in stock indices; their correlations rise and index volatility rises with it.
This makes for a fragile environment. As we saw in the “Flash Crash” of 2010, when correlations are high and dispersion is low, even a small and otherwise minor market disruption can have catastrophic consequences. This is the “bad” kind of market volatility, with few stocks providing refuge and little benefit to diversification. Be careful out there…
This article was written by Tim Edwards, senior director, index investment strategy, S&P Dow Jones Indices.
© S&P Dow Jones Indices LLC 2013. Indexology® is a trademark of S&P Dow Jones Indices LLC (SPDJI). S&P® is a trademark of Standard & Poor’s Financial Services LLC and Dow Jones® is a trademark of Dow Jones Trademark Holdings LLC, and those marks have been licensed to SPDJI. This material is reproduced with the prior written consent of SPDJI. For more information on SPDJI, visit http://www.spdji.com.