Sunday, September 11, 2011

The rising risk correlations

"The correlation between the biggest 250 stocks in the S&P 500 over the past month has reached its highest since 1987 this week, at 81 per cent, according to JPMorgan figures. This means those stocks move in the same direction 81 per cent of the time. The historical average is 30 per cent. The measure peaked at 88 per cent during the October 1987 US crash, when the Dow Jones Industrial Average fell 22 per cent in one session. Other spikes in correlation, including the collapse of Lehman and the Japanese earthquake, peaked at about 70 per cent but quickly fell away."

The FT article is a strong pointer to a repeat of the 1987 crash. The high correlations provide a circular ring to volatility. Higher volatility puts pressure on VaR limits, forcing traders to pare back their positions, which in turn drives the correlations further up. In these conditions, a small trigger can set off a cascade, bringing down the markets.

The other barometers of market uncertainty too are on the rise. The CBOE Volatility Index, VIX, which measures the prices of S&P 500 index options 30 days ahead, is at nearly three times its historical average and has remained there for more than a month now.

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