Understanding Correlations and Market Volatility

Our head of corporate credit research dives into the question of correlation and market volatility, and explains why stock indices can remain stable despite a certain level of turmoil, as we have seen recently in Europe.

----- Transcript -----

Welcome to Thoughts on the Market. I'm Andrew Sheets, head of Corporate Credit Research at Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about correlations, and why they are currently so important to markets being calmer than they would otherwise be. 

It’s Thursday, June 20th at 2pm in London.

Imagine you’re on a boat, maybe looking for sea life. People are milling around the deck, watching the vessel ripple through the waves. Suddenly someone spotsa whale, and everybody runs to port. The whale swims under the boat, and everybody now runs to starboard. The boat rocks significantly. 

But imagine the same scenario where marine life is popping up on both sides of the vessel. You and your fellow passengers are all now running past each other in both directions. The movements balance out. The boat is pretty stable. 

Believe it or not, this is how the volatility in the stock indices work. The individual passengers can be thought of as individual stocks, and how much they’re each moving around can be thought of as each stock’s volatility. The boat is the overall index – say, the S&P 500, the EuroStoxx 50, or an index of corporate bonds. 

When everybody on the boat moves together, what we’d call a high correlation environment, you’d get a lot of rocking, or volatility, at the index level. But when people are moving in opposite directions, moving past each other; you can still have a lot of running, or individual vol – but the market, or the boat, will appear much more calm. 

That is exactly what’s been happening, especially last week. Stocks within the S&P 500 are moving with unusual independence from each other, running to opposite sides of the boat, with the lowest such correlation in almost 20 years. That is a big reason why, despite all the volatile headlines out of Europe, and more stocks falling than rising in the US, the overall market has been surprisingly calm – and going up. 

Even in Europe, this phenomenon of low correlation has really helped. That volatility I mentioned relates to upcoming elections in France, which led the difference between French and German bond yields to jump to their highest level in more than a decade. 

But because this spread of France to Germany moved in the opposite direction as overall French yields, the overall result for French government bonds was not much. Last week, despite all the apparent ruckus, the yield on French government bonds was basically unchanged. Markets have been calmer than you would usually expect them to be. 

These correlations are a big reason why. 

We think they suggest a still healthy dynamic where markets are differentiating between different types of risks. To go back to our original analogy, there is still plenty of sea life out there for the market to look at. But these correlations are also worth watching, were they to rise significantly. If one thing were to dominate the focus and lead everybody to run to the same side of the boat, overall market volatility could rise surprisingly fast. 

It's something, you could say, that we're on the lookout for. 

Thanks for listening. If you enjoy the podcast, please leave us a review, wherever you listen, and share Thoughts on the Market with a friend or colleague today.