The CBOE Volatility Index is one of the most important indicators for understanding stock market sentiment. A key reason for the recent increase in market volatility is the increase in correlation between the index's constituent stocks.

The VIX is not designed to be a "fear index," although it is often interpreted as such in the media. In fact, it is a measure of S&P 500 (SPX) options to predict market volatility over the next 30 days. An often overlooked factor is the correlation between the components of the S&P 500. High correlation leads to higher index volatility, and vice versa.

Let's use a simplified example to illustrate this. Suppose there is an index made up of two stocks with equal weights. If the two stocks are perfectly correlated and both go up 10%, the index will also go up 10%. But if the two stocks are inversely correlated, and one goes up 10% and the other goes down 10%, then the index will remain the same.

In both cases, the stock's daily volatility is 10%—remember, volatility measures how much a stock price moves up or down—but the volatility of the index varies greatly due to different correlations between stocks.

Of course, when we’re talking about an index of 500 stocks, all with different weights and volatilities, the calculations become much more complicated. Fortunately, the CBOE offers a range of correlation indices that quantify the difference between the SPX and individual stock implied volatility. Because correlations can change over time — for example, stocks with a weak short-term correlation may be more closely related over the long term — the exchange offers correlation metrics for different time periods. I find the CBOE 1-month Implied Correlation Index (COR1M) very useful when comparing it to the VIX, as the two use very similar time frames.

A rule of thumb is that correlations increase when markets are falling and decrease when markets are steadily rising. Considering that the largest technology stocks (i.e., the “Big Seven”) have dominated market performance for much of this year, while most of the S&P 500 has lagged, it’s not surprising that COR1M has spent much of 2024 hovering near all-time lows. In fact, the all-time low was reached on July 12. VIX is also approaching post-pandemic lows, reaching an absolute low of 10.62 seven days later.

However, something interesting happened at the time, perhaps a "signal". From June to early July, COR1M fell sharply, while VIX, although low, remained relatively stable. Since VIX can be used as a proxy indicator of short-term protection needs of institutional investors, the fact that VIX did not continue to fall like COR1M shows some caution in the market. The S&P 500 peaked on July 16, although the initial decline was smaller.

In August, the situation changed dramatically. The "carry trade" in which hedge funds borrowed low-yielding yen to buy better-performing assets such as technology stocks collapsed, leading to a broad but short-lived sell-off. The VIX surged and the correlation rose with it. When the VIX reached 65, the COR1M hit a high of 76.91. However, while stocks have largely recovered, the COR1M has only returned to the mid-20s. The rotation of leading sectors has depressed the correlation, which also explains why the VIX is still high and has not returned to the mid-level level at the beginning of the year.

To be sure, investors are also aware that volatility could rise in the coming weeks — a period that includes the Federal Reserve meeting and the upcoming, unpredictable election. A rise in the VIX is like a rise in the price of an umbrella when rain clouds appear, and the correlation can be seen as a barometer.

Article forwarded from: Jinshi Data