How low is the internal correlation of U.S. stocks? Only on the eve of the 2018 "volatility doomsday" was it lower than it is now.
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Analysis indicates that the current internal correlation within US stock sectors has only been lower prior to the surge in volatility and stock market crash of 2018. The VIX has retreated below 20—considering the ongoing war situation in the Middle East and the near complete shutdown of one of the world’s most important commodity routes, this performance is quite unusual.
There may be a hint of complacency in the market, but it has not reached the levels seen from 2017 through early 2018. At that time, the VIX hit historic lows—even lower than its readings before the 2006 financial crisis and below the mid-1990s levels when the US economy began to take off.
An important indicator for measuring complacency and macro vulnerability is sector correlation.
Overall, the average pairwise correlation coefficient among S&P 500 constituents, as well as the correlation coefficients between S&P 500 sectors and major tracking factors (based on Bloomberg), have only been lower in the run-up to "Volmageddon"—that is, before the extreme volatility spike in early 2018.
This is particularly anomalous in the current macro environment. Common drivers such as energy shocks and geopolitical economic factors should logically push correlations higher, yet reality is just the opposite.
Looking back to 2017-2018, the macroeconomic environment was stable, rates were still near zero, and it was popular in the market to short volatility using reverse VIX ETF products such as XIV and SVXY. As volatility declined, speculators had to sell more positions to achieve the same returns with each point VIX declined.
Such ETF products are no longer popular today, but this does not mean short volatility positions have vanished—they now exist in large scale under other forms: algorithmic strategies selling put options, risk parity strategies, volatility dispersion trading, etc.
Recalling 2018, short volatility trades became increasingly crowded until the moment of liquidation arrived. On February 5, 2018, US stocks dropped 4% in a single day, VIX surged, triggering a massive short covering in volatility index shorts—related ETFs were forced to rebalance before the close to maintain target exposure. The VIX briefly broke above 50 during the session.
Structurally, index volatility (VIX) equals the product of average single-stock volatility and correlation coefficient. Thus, even if individual stock volatility is not low, low correlation can still keep the VIX at a low level.
This is exactly the current situation: although single-stock volatility remains high, the VIX continues to fall as correlations drop. However, this precisely exposes an obvious breaking point:
Once a shock occurs—whether exogenous or endogenous, correlations will quickly rise, the VIX will surge sharply, and stock prices will then be more prone to plunging chaotically.
Risk Warning and DisclaimerThe market is risky, investment requires caution. This article does not constitute personal investment advice, nor does it take into account the specific investment objectives, financial situation, or needs of individual users. Users should consider whether any opinions, views, or conclusions in this article are suitable for their particular circumstances. Investment based on this is at your own risk. ```