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Here’s the hidden stock-market risk investors need to watch out for


U.S. stock-market investors have plenty of potential headwinds to monitor, a list that includes trade policy, central-bank policy, and rises in commodity prices, inflation, bond yields, and the U.S. dollar, but one of the biggest risk factors may be essentially invisible.

Correlations, or the degree to which two different securities move in tandem, could be prone to spikes, which would create a trading environment where stocks broadly move in the same direction, regardless of their individual or underlying fundamentals. The last time this happened, in February, it contributed to a stock-market correction that the Dow Jones Industrial Average 

DJIA, -0.16%

 and the S&P 500

SPX, +0.12%

still haven’t fully recovered from.

While broad-market correlations have been receding since February, major indexes have at the same time been taking their cue from technology stocks, which have led the market higher for years and could just as easily lead it lower.

“Increasing stock correlations within equities are additionally making it harder for investors to look for diversification by simply investing in equities. Thus, beating markets through simple stock selection is getting harder,” wrote Gaurav Sinha, a strategist at WisdomTree. “We are now entering a regime where higher correlations are feeding higher volatility. In my view, higher volatility (compared to 2017) is here to stay.”

According to Sinha, rising correlations are a leading indicator for the Cboe Volatility Index

VIX, -1.61%

meaning that as correlations increase, market volatility is likely to follow.

Courtesy WisdomTree

According to data from S&P Dow Jones Indices, the daily correlation for the S&P 500 averaged 0.373 in April, a fairly typical figure. A reading of zero would mean no correlation, while perfect correlation would be expressed as a reading of 1.0. Periods of low correlation typically go hand-in-hand with low-volatility environments, as the market’s gainers end up offsetting the losers. When a majority of stocks are moving in the same direction, the daily moves in the broader indexes are obviously higher.

Correlations hit a multiyear low of 0.099 in December, but surged to 0.595 in February. They moved lower over the subsequent two months, and are on track for another monthly drop in May, as recent readings have come in under 0.2.

However, while broad-market correlations have been dropping, the S&P 500 remains highly correlated to technology stocks. According to DataTrek Research, correlations between the sector and the index have been around 0.95 since February, meaning the two are moving in near-perfect lockstep with each other. That has helped the market recently, as tech remains the strongest-performing sector of the year, but “in terms of portfolio diversification, it is a dud,” wrote Nicholas Colas, DataTrek’s co-founder.

Earlier this month, DataTrek calculated that the price correlation between the average S&P 500 sector and the index overall was 0.75, up from 0.55 last year. “In other words, the daily move in the S&P 500 ‘explains’ +50% of any sector’s one-day price action now versus just 30% last year,” Colas wrote.

Courtesy DataTrek Research

The higher sector correlation is occurring at a time when overall market volatility has been low, having also receded from a spike in February. The Cboe Volatility Index

VIX, -1.61%

 , a popular gauge that measures options investors’ expectations for volatility over the coming 30 days, is currently trading around 13, well below its long-term average between 19 and 20.

“Don’t be lulled into a sense of false security now that the VIX is back to 13 and everything feels more ‘normal,’” he wrote. “Still-high correlations mean even small shocks will quickly transmit through to equity markets.”

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May 22, 2018

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