In 2011 and early 2012, one of the big themes was the elevated correlation among individual stocks. In the "risk on, risk off" environment, investor appetites for stocks were indifferent to the fundamentals of particular companies: trades were all about the macroeconomic risks.
You can get a sense for the major swings in stock correlation by looking at the three month correlation among the Dow Jones Industrial Average components since 2008 - see the top panel in fig. 1. The extent to which stocks traded together during the debt ceiling panic and the worst phase of the European banking crisis in 2011 was actually greater than during the 2008 market decline.
The one month estimate in the lower panel is noisier, but it shows changes in stock co-movement more quickly. One month Dow correlation fell to 19% this spring and again to 23% in October, but has spiked higher more recently, presumably as markets have declined over 'fiscal cliff' worries. The political environment has looked more favorable over the last week than it did at any point during the debt ceiling negotiations, and there are very important differences between that situation and the present one. If investors conclude that a more lasting resolution is likely after January 1st, we could see markets calm down in the short term. (I published a thorough review of current market volatility yesterday at Condor Options.)
If we see stock correlation continue to rise, whatever the cause, investors should focus on managing the big-picture risks and wait to make new stock purchases until the statistical storm has passed.
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Jared can be followed on Twitter at twitter.com/CondorOptions.
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