With the dramatic movements in the stock market over the last few weeks, we feel it is important to look at the underlying sectors of the market to see how they are performing relative to one another and the market as a whole.  This week’s chart examines the S&P 500 Index’s implied correlation as well as correlations among the various S&P 500 sectors.  Below, please find a quick reference to what correlation is:

• +1.00 = implies the two series move in lockstep in the same direction
• 0.00 = implies the movement of the two series in completely random
• -1.00 = implies the two series move in opposite directions

The graphic above shows the CBOE S&P 500 Implied Correlation Index (“KCJ”) which depicts the January 2012 maturity S&P 500 implied correlation option estimating of the average correlation of the stocks that comprise the S&P 500.  Over the last 22 months (November 23, 2009 – August 15, 2011), the implied correlations has averaged 65.48.  This equates to a 0.65 correlation level, a strong level of positive correlation.  Since the S&P began its downward slide on July 22^nd, the correlation level crept upward from 0.55 to 0.76 on August 8^th.   This increase is very similar to the spike following the “Flash Crash” in May 2010. This implies that as the market fell, the stocks of the S&P moved together more than they had previously.

Another way to view correlations is to analyze the individual S&P 500’s sectors’ behavior with each other.  This does not have the option bias that the data above has. Evaluating the same time period of 11/23/09 – 08/15/11, all sectors have had positive correlations with the market as a whole (S&P 500) and each other.  The only apparent weaker correlation, though still positive, is financials.  During this time period, financials is the only sector with negative performance.  

Exhibit 2:  GIC Sector Correlations (11/23/09 - 08/15/11)

An even more dramatic look-through is the volatile period of 07/22/11 – 08/15/11.  This is evidence that all stocks moved in lockstep during the most recent market slide.  Correlations tend to spike in times of extreme market movements, dramatically decreasing the benefits of diversification.

Exhibit 3:  GIC Sector Correlations (07/22/11 - 8/15/11)