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As Jill and I discussed in the video below, it's been fascinating to watch the swings in equity correlation over the last several months. Both realized correlation among the returns of S&P 500 components and changes in the forward-looking correlation implied by options markets give us some interesting things to watch.
CLICK HERE TO VIEW VIDEO
The average one-month correlation among S&P 500 components was actually higher in the fall of 2011 that at any point in the past five years, including during the 2008-2009 financial crisis. Then rally into the end of the year and in the first quarter of 2012 pushed stock correlation toward 40%, which is much lower than average. The flat-to-down trading in recent weeks has pushed overall realized market correlation back toward ordinary levels closer to 60%.
As we've noted before, paying attention to these swings in correlation is important because it tells us what kind of market we're dealing with. When average stock correlation is high, it means the market is being driven by exogenous, usually macroeconomic factors. In that kind of environment, paying attention to the fundamentals of individual companies is less important than getting the bigger picture in focus. When average stock correlation is low, it means that the price returns of any given stock are more likely to depend on fundamentals and earnings -- in other words, a low correlation market is a stock picker's market.
Right now, we're not at an extreme level of realized correlation in either direction, which means there is a mix of factors in play. One way we've been trading this type of market is by putting on both macro-focused trades and positions in stocks showing resilient momentum. For instance, we have positions open in CurrencyShares Euro Trust (FXE), CurrencyShares Japanese Yen Trust (FXY), and iShares Russell 2000 Index ETF (IWM), but also trades in specific stocks like Lowe's (LOW) and Yum! Brands (YUM).
As for option implied correlation, it looks like traders are pricing in lower stock correlation for the future. While one-year implied correlation remains above levels we say in the mid-2000s, perhaps reflecting higher concerns about persistent systemic risk, options markets are pricing in about the same expected 1Y correlation that we saw for most of 2011.
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