Rebellion in Russia. A hawkish Federal Reserve. Faltering economies abroad. Together, they might be causing the stock market to recoil in fear. Instead, the
S&P 500 index
is as calm as it’s been in years. Underneath the surface, however, investors appear less complacent than index-level volatility measures suggest.
Signs of even mild concern are certainly hard to spot. Lately, the
Cboe Volatility Index,
or VIX, has been bouncing around near 13, a level not seen since before the Covid-19 pandemic. If the VIX, known as the market’s fear gauge, is to be believed, investors are as frightened as a mouse in a cheese factory while the cat’s on vacation.
Yet the VIX is deceptive, says Matt Rowe, head of cross-asset strategies at Nomura Private Capital, by suggesting there’s calm in the market that’s not really present. For evidence, he points to the Cboe 1-Month Implied Correlation Index (COR1M), a measure of how much individual stocks are trading in lockstep. It’s constructed by comparing the price of options on the S&P 500 to those on the top 50 individual stocks that make it up. It weighs investors’ collective expectations of how volatile the index will be relative to its components, and is trading at 13, its lowest level since 2017.
Put differently, when implied correlation is low, dispersion is high—individual stocks are moving around in different directions a lot more than the index is. For every Carnival (ticker: CCL), up 46% in the past month, there’s an
Advance Auto Parts (AAP),
which is down 40%. “In a market with a lot of changing components and crosscurrents, you tend to get a lot of dispersion, as we are seeing now,” Rowe says.
That helps explain why volatility appears to be so low. A stock index is, after all, an index of stocks. If half of the components in the S&P 500 rise in a day and the other half fall, the index will be unchanged and index-level volatility will be sleep-inducing. It obscures the volatility under the surface.
Sometimes the opposite is true. The ultimate period of high correlation in the S&P 500 was in March 2020, when the onset of the Covid-19 pandemic prompted a dash for cash. Investors reduced their holdings of practically all stocks, sending them sharply lower in unison. The 1-Month Implied Correlation Index jumped to 87 points, while the VIX hit 83. Don’t expect that kind of spike without some sort of crisis, but the low-index-volatility, high-dispersion backdrop won’t last forever. “We don’t need a shock to get more index volatility, just a return to normal,” Rowe says.
One catalyst for a volatility rebound could be second-quarter earnings season, which begins in mid-July. Many stocks are up a lot going into their coming reports. There’s potential for a sell-the-news earnings season should management teams remain cautious or results disappoint. Whatever the cause, Deutsche Bank strategist Parag Thatte argues that the S&P 500 is due for a modest selloff. The index hasn’t had a 3% drawdown since March—putting the duration of the current rally in nearly the 90th percentile since World War II.
“Correlations are now at lows previously seen only in late 2017/early 2018, right before the ‘volmageddon’ selloff,” Thatte writes. “A pickup in correlations would drive vol higher and has historically been associated with a market selloff.”
For investors looking to hedge, buy put options—which increase in value when a security falls—on the S&P 500, where volatility is lower and prices are cheaper than on individual names.
For everyone else, watch out for the cat.
Write to Nicholas Jasinski at [email protected]
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