Hidden Fear Gauge Gives Bullish Sign for Stocks Near Record
(Bloomberg) -- Stocks dancing to their own tunes is the latest sign markets are regaining some of their swagger in the wake of the Covid-19 crash.
Spurred by earnings season, implied correlation among shares in the S&P 500 Index recently slumped to the lowest since February, according to a Cboe benchmark.
Sometimes referred to as an alternative fear gauge, falling implied correlation typically corresponds to lower volatility as individual share moves cancel one another out. While not necessarily a bullish signal on its own, it can be a sign of a healthy market that benefits active managers and systematic strategies alike.
“With correlation below 50, as well as measures of implied correlation, the market appears to be returning to a ‘normal’ type of price action, with some sectors winning and others losing on the same day,” Eric Johnston, head of equity derivatives and cross asset at Cantor Fitzgerald, wrote in a recent note.
That’s potentially a good sign for a breed of investor that chases factors, or stocks sharing characteristics like cheapness, as a “majority” perform better when correlation declines, according to Evercore ISI strategist Dennis DeBusschere.
The calm comes as investors adjust to a world of fluctuating Covid-19 case counts and recurring regional lockdowns, soothed by support from central banks and governments throwing massive stimulus at their economies to mitigate damage from the pandemic.
The S&P 500 Index is flirting with a record, while the Cboe Volatility Index, or VIX, has dropped to 22 from its high of 83 in March. One-month realized correlation, a measure of how shares have actually moved, has also dropped to the lowest this year.
“The fact that correlations have declined during earnings season is not surprising, but what stands out this time is the magnitude of the decline,” said Mandy Xu of Credit Suisse Group AG. “I would point to falling correlation as one of the drivers of lower index volatility in recent weeks.”
Still, investors cheered by signs of calm shouldn’t necessarily see this as an all-clear, Cantor’s Johnston cautioned.
“With VIX back in the low 20s, we’d revisit renting vol by buying outright VIX calls,” he said, suggesting September 40 contracts. At these levels, it wouldn’t take much of a pickup in correlation or changes in other such measures to make owning those options profitable, he said.
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