(Bloomberg) -- US stocks are increasingly moving in tandem, raising the risks of further turbulence ahead as investors grapple with uncertainty over economic growth and the potential fallout from President Donald Trump’s trade policies.
With the S&P 500 now down around 6% from its all-time high, an index of three-month implied correlations from Cboe stands at its highest level since a selloff rattled global markets in September. Lockstep moves in equities are a red flag for traders, as they can indicate an environment where good stocks get hit along with bad ones when risk appetite dries up.
“The spike in correlations are a warning sign that additional stock pain can’t be ruled out,” said John Kolovos, head of technical strategy at Macro Risk Advisors.
The phenomenon has presaged past episodes of short-term stock weakness. The S&P 500 has posted an average loss of nearly 9% in the 20 days after three-month implied correlations topped 65-day highs with the benchmark stock index hovering near multi-year peaks, as it is now, according to Macro Risk Advisors data going back to 2007.
At the same time, however, “these spikes ultimately produce sentiment extremes where stocks end up higher six months out,” Kolovos said.
The spike in implied correlations is a shift from the beginning of the year, when the measure stood near historic lows following a rally that accelerated after Trump’s victory in November’s presidential election. Low correlations can be a positive sign for markets, as they suggest company-specific fundamentals are swaying prices, rather than worries over broader macroeconomic risks.
Conversely, large-scale macro worries - such as the tariffs on Canada and Mexico and increased duties on China imposed earlier this week - can often cause stocks to fall together, with investors paying less attention to individual companies’ fundamentals as fear grips markets.
That was the case in late 2018, when trade tensions and worries over Federal Reserve policy buffeted a tightly correlated stock market, leading the S&P to fall almost 20% from its high at one point. Despite recent swings, correlations are far lower now, with the three-month index at 22, compared to a high of 46 during the 2018 selloff.
Volatility has picked up further ahead of Friday’s monthly jobs report. The Cboe Volatility Index, or VIX, is at its highest since December — topping the 20 level that traders view as signifying a more turbulent environment. A gauge of implied volatility in the VIX Index — the VVIX — is hovering 23% above its one-year average.
Still, there are signs the latest bout of stock swings may not last long.
A ratio comparing Cboe’s index measuring one-month correlations to its three-month counterpart stood at 1.2 on Tuesday, near the top of its range since 2009, according to data compiled by Bloomberg.
Historically, it’s been rare to see the indicator rise much further from current levels, said Colton Loder, managing principal of Cohalo, an alternative investment firm.
“This means that the spike in implied correlations and volatility may prove to be short-lived,” he said.
