One of the most common themes of our “Data” section work is that even the most commonly used measures of stock market performance or volatility are not directly comparable across time. For example, the S&P 500 of 2020 is fundamentally different from the S&P 500 of 1980 or 2010 because Technology is such a larger part of the index now versus then and other groups like Energy are much less important.
The CBOE VIX Index is another good case study. It is called the “Fear gauge” because it typically goes up when stocks go down. But just like the S&P 500 has different sector weightings across time, the VIX has to discount 2 distinct drivers of S&P 500 volatility that don’t always have the same impact on asset prices:
- Macro-driven price moves which influence all stocks, such as Fed decisions and fiscal policy trends
- Micro-driven industry fundamentals like corporate earnings
To determine which factor dominates stock prices and therefore volatility, we look at daily price return correlations between sectors like Tech or Health Care and the S&P 500. When correlations are high (0.90 or above, for an r-squared of +81%) you know macro is driving US stock volatility. When correlations are low (sub 0.7, r-squared 49%), markets feel the macro backdrop is predictable enough to make differentiating among sectors worthwhile.
Here is the average 30-day sector correlation for large cap Tech, Health Care, Financials, Comm Services, Consumer Discretionary and Industrials over the last year (orange and blue lines, left Y axis) as compared to the S&P 500 (grey line, right Y axis). The blue line doesn’t include Tech in the average correlation calculation; the orange one does. They’re very similar but it’s worth showing both to make that point.
Now, we’ve been looking at sector correlation data every month since October 2009, so trust us when we tell you we’ve never seen anything like this over just 1 year. Here’s what we see that is so unusual and what we think it means:
#1: Some parts of the orange/blue lines’ trajectories do make sense. Correlations were very high last August-September (+0.9) as markets worried about US-China trade talks. Once those were settled, correlations started to fall slowly (October), then more quickly (November), and then rise again as concerns over global growth increased again.
Takeaway: August 2019 to February 2020 shows stocks can rally with either high or low correlations between individual sectors and the market as a whole. You’d expect that: good news comes in macro and micro forms.
#2: And then we get to the middle part of the chart – March to May 2020 – when stock prices fall apart, correlations go to 0.99, and stay above 0.90 for 3 months. This was as pure a panic phase as you’ll ever see, very much akin to 2008.
Takeaway: the VIX hit an all-time record on March 16th at 83 because correlations went to 0.99, showing that no major sector was immune from the selloff. That’s macro news driving stock prices down (COVID fears), but correlations (and therefore the VIX) remained high as fiscal/monetary policy kicked into gear and stock prices recovered.
#3: Finally, we enter the current phase of the post-COVID market environment, which is a manic seesaw between macro (the need for further fiscal stimulus) and micro (picking sectors and stocks that might outperform). Correlations of 0.9 between mid-June and late-July show when macro concerns held the reins. Their precipitous drop to 0.65 since the start of August highlights when cyclical rotation (driven by confidence in a sustainable economic recovery) suddenly pushed some groups further away from just tracking the S&P 500.
Takeaway: this is why we say you can’t compare the VIX across time, because as we stand today correlations are very low (0.65) and yet the VIX is still 22. The last time correlations were this low (late November 2019), the VIX was at 12.
Summing up: the chart above shows how quickly markets have shifted to trying to game the nature of an economic recovery (lower correlations), and at current levels it is right to think we may get another round of macro concerns quite soon. If the VIX at 22 is telling us anything, we think that is its central message. This isn’t a “Sell everything” sort of signal, but rather “let’s be careful out there”.