Not that long ago, we noted that S&P 500 implied correlation was marching to new all-time highs, suggesting that investors were better served to focus on major economic risks rather than looking just at the details of individual stocks.
About one year later, we can write instead that S&P 500 implied correlation is pushing to new lows.
CBOE S&P 500 Implied Correlation Index (January 2013). Source: CBOE, Condor Options
The biggest risk scenarios that have worried investors over the past several years have begun to fade: the ECB news last week provided renewed confidence that ill-advised risk-taking by European banks will not be allowed to ruin the currency union, and the prospects for a double-dip recession in the U.S. are much lower now than they were a year ago. Implied correlation fell further last week, to 53.16, after the Fed announcement of further quantitative easing.
This decline is important because high implied correlation was one of the lingering effects of the financial crisis. Elevated implied correlation among stocks had persisted well after other measures of economic and financial health, like credit conditions (TED spread) and equity implied volatility (CBOE Volatility Index (VIX)), had returned to pre-crisis levels. The fact that the implied correlation index is drifting toward the 40-50 range provides further evidence that investors are focusing more on the fundamentals of individual companies and less on index-level risk scenarios. If the Fed’s new quantitative easing program is able to put a floor under the economy, we can expect equity implied correlation to decline further in the coming months, which, on balance, is a good thing for investors.