Stock-market volatility has subsided after a February spike, and there’s a reason to think it will remain under wraps in the near term.
That’s because the exceptionally low volatility that prevailed in 2017 could be explained by the equally low correlation between S&P 500 sectors. A downward shift in correlation — a measure of the degree to which assets move in relation to each other — points to less volatility in the coming months, according to Nick Colas, co-founder of DataTrek Research.
The relationship between U.S. sector correlation and stock market volatility is very clear, Colas said.
“When correlation is falling, it drives volatility down. But a spike in volatility, the kind we saw in February, drives correlation between sectors up,” Colas said in a phone interview.
So the latest decline in volatility, therefore, has been driven by declining sector correlation.
The Cboe Volatility Index
or VIX, has fallen 40% since early April, settling at 12.34 on Tuesday, near its 2018 lows. Last year, VIX, which measures expectations for volatility over the coming 30-day period, spent most of the year below 10.
Similarly, the mean correlation for U.S. sectors to the index in 2017 was 0.55, about a third lower than the 2010-2016 average of 0.83, Colas said.
A perfect correlation reading of 1.0 would mean that sectors were moving in lockstep; a reading of 0 would reflect zero correlation, with sectors moving completely independently of one another. A reading of -1.0 would reflect a perfectly inverse relationship.
Earlier this year, when volatility spiked and the S&P 500
fell more than 10%, correlation between sectors also rose, peaking in March at 0.87. However, since then U.S. sector correlation has fallen to 0.68, according to Colas.
“The decline in sector correlations from the March highs (caused by the February volatility spike) runs across every major industry group,” Colas wrote in a note to investors.
Correlation between individual sectors and the broader index also has been falling by hefty margins in what Colas describes as a “broad-based reset.”
Low volatility and low correlation boosted investor confidence, with stock prices gaining ground so far in the second quarter. The S&P 500 is up more than 5% quarter-to-date, largely driven by a rally in technology stocks, that make up more than a quarter of the entire index.
The two big forces that led to the breakdown in correlations over the past 18 months — fiscal stimulus measures such as tax cuts, as well as deregulation and a rise in long-term interest rates — are still in play, according to Colas.
“Absent an exogenous shock (and it would need to be a big one), these fundamentals aren’t changing any time soon,” Colas wrote.
But that doesn’t mean that investors should pencil in low volatility for the rest of the year.
“U.S. equity volatility is seasonal — we could see some churn (and therefore higher correlations) in August or October, the two typical high water marks for volatility,” Colas said.
But for now, falling correlation points to less volatility rather than more in the weeks and months ahead.