Volatility, Dispersion & Correlation – Friends or Foes?

Reading Stock Market Tea Leaves.

September 2018. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • Higher volatility & dispersion imply higher stock market risks
  • The relationship between correlation and risk is not linear
  • However, these market technicals do not behave consistently across time

INTRODUCTION

Financial reporters frequently comment on stock market technicals like volatility and correlation, although most investors struggle to process this information adequately. The VIX jumping by 20% sounds concerning until compared to the historical volatility of the index, where increases or decreases of similar magnitude were frequent. In recent years, higher stock market volatility was typically associated with falling stock prices and a potential harbinger of a stock market crash. However, in the years leading up to 2000, volatility was high and stock prices were increasing. The implications of changes in stock market technicals on returns and risks are complicated. In this short research note we will investigate volatility, dispersion and correlation of the US stock market (read Low Volatility, Low Beta & Low Correlation).

METHODOLOGY

We focus on volatility, dispersion and correlation of the US stock market for the period from 1988 to 2018. Volatility is measured by realized returns of the stock market with a one-month lookback. Dispersion is calculated as the absolute differences between stock prices and the market average on a daily basis, which is then averaged over a one-month period. Correlation is derived from the pairwise correlations of all stocks in the universe measured over a three-month lookback.

VOLATILITY, DISPERSION & CORRELATION IN THE US

The chart below highlights the volatility, annualised dispersion and correlation of the US stock market from 1988 to 2018. Bull markets can broadly be categorized by exhibiting low volatility and dispersion. Stock correlations appear to have structurally increased since the 2000s, perhaps reflecting more integrated capital markets. Some investors are concerned that ETFs lead to higher stock correlations, but 2017 and 2018, where passive investments reached a new record in terms of market share, exhibited exceptionally low levels of correlation.