Correlation Spikes: Why Are You Still Picking Stocks?

The last time we checked in on the CBOE S&P 500 Implied Correlation Index ("Analyzing My Options"), it had moved to a new high above 81. Since then, the index continued to rally as every creeping thing with a ticker symbol moved in tandem with every other thing. KCJ topped out above 90 before falling this week back to 75, which is still a very high reading and a sign that nobody expects stocks to move independently anytime soon. 

CBOE S&P 500 Implied Correlation Index

Source: thinkorswim

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But maybe you're skeptical; maybe you have a burning need to allocate some capital to the next three value traps that manage to eek out an extra penny or two more than their already-slashed earnings estimates require. You could object that implied correlation is just a forward-looking estimate, and you'd be right. These indexes - KCJ, JCJ, and ICJ - give estimates targeted to fixed dates based on option prices in the 50 largest S&P 500 stocks and SPX options. In that sense, just as implied volatility is "only" an estimate of future volatility, and so is distinct from the actual price volatility that has already occurred, so is implied correlation a slightly different animal than the actual correlation that has already occurred. Maybe the implied correlation will be horribly wrong, and this period will prove to have been a shining moment for brazen stock pickers, right? 

Recent Equity Correlations

Source: ConvergEx

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Wrong: not only are options markets preaching the gospel of high correlation, but price action tells the same story. Fig 2 (hat tip FT Alphaville) shows correlations of all the major equity sectors to the S&P 500 on a monthly basis, along with rolling data from the last three months. The conclusion: stocks - including international stocks - are all one big bet. Even the Australian dollar and the euro ( (FXA) and (FXE)) showed high correlations to SPX last month.

The situation right now is that macroeconomic news matters and almost nothing else. Sure, a company that crushes earnings estimates or decides to completely change its business model, only to change it back a few days later (ahem, Netflix (NFLX)) will see some independent price movement. But on the whole, an investment in any individual stock right now is at least 90% an investment in the market in general. I wouldn't color this as necessarily good or bad news, and passionate value investors can always keep doing research to sock away until that work is relevant. But until markets get some clarity on global prospects for growth and some resolution of the several pending crisis scenarios, diversification is only possible by trading multiple asset classes, and not just equities.

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At the time of publication, Jared Woodard held no positions in the stocks or issues mentioned.