Do Investors Own What They Think They Own?

For most of this year the S&P 500 looked calm, but largely because its components were moving in different directions and offsetting each other. That is a fragile kind of calm. In the first week of November, it broke. Correlation snapped back, the Nasdaq-100 Index fell 6.4% on November 5 alone, and it now sits 13.6% below its October 6 high. The S&P 500 Index is 5.7% below its own high.

The Old Regime: Diversification Was Doing the Heavy Lifting

Into the end of October, the 50 largest S&P 500 Index stocks had an average correlation of about 8%, lower than 96% of readings since 2020 and as low as 5% in July. The average S&P 500 Index stock was moving at about 33% annualized, while the index moved at just over 10% (three-month look-backs). The gap is diversification: stock moves were largely cancelling each other out, which is why the index looked calm.

Calm on the Surface, Disagreement Underneath

Underneath the relative calm, the index and its components had disagreed more than ever before, based on our research. The S&P 500 Index and the majority of its members have moved in opposite directions on 33% of trading days this year, the most since at least 1997 and well above the 9% of a typical year.

Then Correlation Woke Up

The calm ended in the first week of this month. On November 5 the Nasdaq-100 Index fell 6.4% and the S&P 500 Index fell 4.4%, and only 73 of the 500 S&P 500 Index stocks rose. The S&P 500 implied correlation index (COR1M) jumped from 9.5 to 22.8 in a day, moving from the lowest tenth of readings since 2020 to about the middle of the range. Realized correlation among the 50 largest S&P 500 Index stocks tripled over the same day, to about 21% from 7%, and the CBOE Volatility Index (VIX) closed at 28.2, its highest level since March 30.

Even after that jump, correlation has not caught up with the size of the move. The Nasdaq-100 Index is 13.6% below its all-time high, yet realized correlation among its 50 largest stocks is 19%, against a typical 41% at that drawdown depth and lower than 99% of comparable periods. The S&P 500 Index shows the same gap to a lesser degree: 20%, against a typical 26% at its 5.7% drawdown.

What Happens If Correlation Keeps Rising

The selloff showed how quickly the calm can disappear. In a hypothetical scenario, holding the same stocks, weights and individual volatilities, S&P 500 Index monthly volatility at what we’re considering normal correlation for this scenario (24% which is the 2020 to 2026 median) would be about 18%, against about 14% today. At 2022-style correlation (45%) it would be about 24%. These are illustrations, not forecasts, and the three-month figures include only two days of the move so far.* The options market is already pricing part of it: the VIX closed at 25.6 on November 6, with COR1M at 21. Correlation had stayed low through oil price risk, sharp bond selloffs and artificial intelligence capital expenditure fears, but there was never a precedent for an indefinite level of rock bottom correlation.

The past week was a live example. Diversification inside the index was high and was masking risk when measured in volatility terms, and when correlation rose, stocks fell together. The same concept applies to portfolios that hold many less-correlated names instead of direct index exposure. In our view, these portfolios can experience significantly more volatility than a calm tape suggests when correlations jump. Testing portfolio risk metrics by shocking correlations to historical levels is one way to determine whether excess equity risk is being taken, and whether portfolios would benefit from the addition of true portfolio diversifiers.

A calm index is not the same as a low-risk portfolio.

*These results are model-based estimates that may differ materially from actual outcomes and are not investor returns.