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ChartBrief 66 - The Implications of Implied Correlations

As the recent selloff in the S&P 500 looks to be over before it really even got started, I thought it would be worth highlighting an interesting, if unusual, indicator that has potential use in market timing for the S&P 500.

It is the “CBOE Implied Correlation Index” – basically another index in the CBOE family alongside the SKEW, VVIX, and the more familiar VIX.

The index is designed to measure implied correlations based on option pricing – you can see the website definition and methodology for more details.

For me the most interesting or relevant piece of information is how does it look as a timing indicator:

The chart above (from the latest Macro Technicals report) shows the indicator against the market (note: I have spliced together the rotating indexes to make a continuous series). Also note I have shown the indicator inverted since that appears to be the most relevant relationship with the market.

In other words, it appears as though periods of low implied correlation are often found around market tops and periods of high implied correlation are often found around market bottoms.

Why would that make sense? Well let’s think about it: typically in a panic or correction or global selloff you tend to see correlations converge within and across asset classes either because whatever is driving the selloff has broad implications or simply because people are panicking and just “sell everything”.

Like many indicators, the signal it sends is not perfect, but it providers another piece of information in building the overall picture.

To end on an ominous note, you’ll notice that currently the indicator is saying that implied correlations are around a 9-year low, so maybe there is more water to go under the bridge on the current selloff…

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