Oct

17

philThe volatility of the market has dramatically increased in the last few weeks. It is often said that the correlations between various markets increase at such times due to forced margin selling. Certainly such a suggestion is plausible on its face but like everything else must be tested.

One can look at the same-day correlations between various macro variables and the S&P. For this purpose the relevant ETFs were chosen. The correlations with SPY are as follows:

Oil                81%
Gold            -32
Tbonds        -53
Tbill             -53
Yen             -64
UK stocks     93
Japan stocks    93
VIX               -86

The most striking is the strong positive correlation with oil. One interpretation is that oil is driven by recession fears just as stocks are. Another explanation may be that oil is being liquidated to finance stock margin accounts just as the pundits claim. Clearly holding oil is not now a hedge against a stock portfolio.

But when we look at gold the correlation is negative. This would tend to serve as evidence against a wholesale correlation of assets being sold. To some extent gold is still a hedge against a stock portfolio. The same goes for treasury paper and the yen. But we do see UK and Japanese stocks being strongly positively correlated. So it appears that many world markets are strongly correlated with each other. Again this may be a sign of coordinated margin liquidation. The strong negative VIX correlation can be interpreted as the markets are now being strongly driven by fear. None of this is predictive but is an interesting descriptive look at where we are now.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008


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