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Analysis: Correlation and the Debt Ceiling

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To know what equity traders are thinking, the two most important sources of information to watch are 1) the prices they pay for stocks and 2) the prices they pay for insurance on those stocks. Interpreting price movements can be tricky, and instead of following chart patterns I like to watch the realized volatility of stock returns and the correlation of returns among stocks and indexes. "The prices they pay for insurance" is another way of referring to option prices, and two key ways to interpret option price changes are to look at changes in implied volatility and in the term structure of implied vol. Those four indicators - realized vol, correlation, implied vol, and term structure - are probably the most meaningful signals of what's happening in the market.

Let's review what each of those signals are saying right now as the debt ceiling crisis intensifies:

1) Realized volatility: is still low, because even though investors are starting to get nervous, stocks just haven't moved very much on a daily closing basis. The one month standard deviation of S&P 500 daily returns is less than 10%!

2) Implied volatility: we looked at this in " VIX and the Debt Ceiling," noting that implied vol has been rising and can be expected to stay high, especially relative to realized vol, while the political situation persists.

3) IV term structure: in two recent posts at Condor Options ( 1, 2), I take a pretty thorough look at term structure and especially how unusual it is to see such a flat term slope while realized vol is low. Historically, this situation justified a bullish bias, since median returns one week and one month later were much better than normal, but of course the risk to a debt ceiling failure is not reflected in those historical statistics.

4) Correlation: the more investors focus on big-picture risks, the more stocks tend to move together. So far, we're not seeing fear creep into either the realized correlation among stocks, or in the future correlation implied by option prices. First, here is the realized correlation of S&P 500 constituents to the index:*

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