There’s No Crying in Correlation

[00:00:00] Hello, this is Dean Curnutt and welcome to the Alpha Exchange where we explore topics in financial markets associated with managing risk, generating return, and the deployment of capital in the alternative investment industry. In the 1992 hit A League of Their Own, Jimmy Duggan, manager of the Rockford Peaches played

[00:00:25] by Tom Hanks, famously screamed, there's no crying in baseball. I'd say there's no crying in Congress either, but John Boehner has repeatedly made it clear that this is not the case. But to be sure, there's no crying in correlation. There just cannot be.

[00:00:40] And today, over the next 13 minutes or so, we'll discuss this interesting statistic with some assessment of why it's so darn high in some places and confoundingly low in others. Now, we all know about this thing called Spurius correlation.

[00:00:55] A favorite book of mine is entitled Just That, in fact by Tyler Weigand. Here we see some real beauties. I mean, did you know there's a 94% R squared between the popularity of the first name Brooklyn and UFO sightings in Kentucky?

[00:01:09] I wouldn't have expected it myself to be honest. I was also surprised by the 95% R squared between butter consumption and wind power generated in Lithuania. But you do learn something new every day. In markets, the study of correlation is a popular undertaking to say the least.

[00:01:27] As the book implies, throw enough data into a machine and some compelling results will eventually pop out. It's really that there's just so much data. Remember, a 10 by 10 matrix has 45 pairwise correlations. Just imagine how many of these are out there waiting for us Wall Streeters to

[00:01:44] proclaim we found the golden goose. Handle with care is probably a good starting point when it comes to correlation. The topic at hand is twofold. First, we'll explore the tendency for the stock and bond market to move together.

[00:01:58] This is either a new, new thing as Michael Lewis might suggest or in the words of the talking heads, same as it ever was. It's all going to depend on the window you choose to entertain the relationship over.

[00:02:10] For me, peak negative correlation between stock and bond prices was the post-GFC, post-Eurozone sovereign crisis era into the pandemic. Why do I say this? Well, we have to believe that stock and bond prices are going to be vastly negatively correlated in a market crisis event.

[00:02:27] But in a generally good stock market environment, let's call it from 2012 to 2019, you've got a correlation of daily returns between the S&P and TLT averaging around negative 40%. Let's skip 2020 and 2021 and do the same calculations since the feds started hiking rates. These numbers aren't a diversifier's dream.

[00:02:50] Over the last year and a half, correlation has been between positive 23 and positive 37. It all fits with how we think about market risk these days. Tail risk has always been a worry for equity investors. Today though, we fret about tails in treasury auctions with a poor one linked

[00:03:08] to a sell-off in the S&P. How about that late August 2023 bear steepening episode on the back of a poorly received quarterly refunding announcement? The causality of risk, typically from a stock market sell-off that leads to

[00:03:22] a bond market rally on a flight to safety is often reversed these days. Stock market investors are rightly, I believe, worried about the fragile dynamics of the US bond market. Let's do a really quick back of the envelope calculation. Let's take a half S&P half TLT portfolio.

[00:03:39] Let's use 15 vol for both assets. And let's use that negative 40% correlation that prevailed from 2012 to 2019 and then use the positive correlation of the recent period and then compare the vol of the two portfolios. In the benign diversifying scenario, your vol is just 8.2.

[00:03:58] But when you move that correlation into positive territory to 25%, you get nearly 12 vol. If you're sizing your portfolio based on realized vol, a habit among most of us, you can be 44% larger when the bond market acts to defray stock risk than when it does not.

[00:04:17] So where the heck can a guy get some diversification around here? Well, don't worry. We've got just the thing for you. You can diversify your stock market exposure with stock market exposure. Forget bonds and certainly ditch those puts.

[00:04:32] The stock market has internalized its hedging system via correlation results the statisticians are abuzz about. It's all one trade said the skeptical naysayer watching the index levitate. I think not. Let me show you some data said the optimist pocket protector in place with

[00:04:48] an HP 12 C ready to go one year correlation among stocks in the S&P is at 15%. We've really never seen anything like it. Just this week, we saw this low correlation dynamic in action on Tuesday, June 11th, Apple surged by 7%.

[00:05:05] Hello, tech as an asset class must have been screaming that day one might be inclined to assume the moves in Nvidia and Microsoft on June 11th down 70 bips and up 1.1% respectively. Over the last 30 days, the correlation between Apple and Nvidia is exactly zero.

[00:05:25] You'll hear me say often that realize vol rules the world. By this I mean that so many pricing outcomes both on an absolute and relative basis in markets are a function of the magnitude of the daily moves in the assets.

[00:05:39] One month realize vol on the S&P is just 8.7 as I speak these words, such a low reading way substantially on how investors evaluate the trade off in taking risk. If gaining long market exposure can be achieved through futures or

[00:05:54] an ETF or a basket of equities linear exposure one might call it and trying to sound smart or through options let's say using a call option. The latter becomes more valuable when the risk of being very wrong is higher

[00:06:08] when realized vol is very low that risk is low too and the demand for options and the price of them will fall. Prices that reflect market risk in options and spreads generally follow what's happening in real time. When realize vol rises so too will implied vol.

[00:06:27] When realize defaults rise so too will credit spreads. The same goes for correlation. When realize correlation plummets as it has implied correlation will follow it lower. When we typically talk about implied correlation in the S&P we are referencing at the money options in the index and

[00:06:44] those of the stocks that comprise the index. Our trusted VCA page on Bloomberg will tell us that three month implied correlation is just 17%. To give you some context this is in the zero with percentile over the last decade, the average is 40%.

[00:07:01] And just as diminutive realize vol weighs on implied vol measures like the VIX it is faltering realize correlation among stocks that results in implied correlation being so low. Over the last three months realize correlation is just 12.5.

[00:07:18] It may be obvious to some but I always find it useful to think about market prices in terms of the P&L feedback that impacts them. The quote dispersion trade as it's called has been around for

[00:07:28] a long time and is implemented by going long vol in the single stocks that comprise an index and then selling an index option against it. The trade is effectively betting that the single stock options are cheap relative to the index option, resulting in an implied correlation level

[00:07:45] that is too high and can be shorted. In the current circumstance, an investor that put this trade on three months ago would have sold correlation at 19%. That's really low in the context of history. But as we have noted, the realize correlation over the last three months

[00:08:01] has been an even lower 12.5%. These trades are complicated and there's often path dependency that muddies the P&L, sometimes for better, sometimes for worse. But the main point is clear. Realize correlation has continued to be lower than implied. There is carry to be harvested.

[00:08:19] And that brings us to a recent closing price worth some explanation and consideration, the haunting 666, a number with lots of debated meaning. In markets, the intraday low of the S&P was reached on March 6, 2009 at 666. On June 5th, another 666 printed and that was three month implied

[00:08:39] correlation of stocks in the S&P at the 10 Delta point. Just like the at the money implied correlation we discussed, this is an awfully low number. The calculation again uses three month implied vol on the names in the S&P

[00:08:54] and compares that to the implied vol on the S&P itself. But instead of using at the money options, we use upside calls, each with a strike price that has a 10 Delta. The 6.66 calc is heavily impacted by the beast, Nvidia.

[00:09:10] A newly minted 3T, the stock was up 27% in May and is up 10% already in June. The price action in Nvidia is such that it has become nearly unshortable. The financial and career risk are simply too high.

[00:09:27] Benchmark hugging stock pickers paid to take on small deviations from the S&P can't afford to do so even if they'd like to. On the other side, FOMO is hard to get away from. When a stock surges and its implied vol follows,

[00:09:40] the market is speaking loudly about its interest in owning optionality and on the flip side, its capacity to provide it to those interested parties. Hedging a short call in a stock up vol up situation is a dangerous exercise where you can get the Delta very wrong.

[00:09:58] The result is that the 10 Delta call in Nvidia has a very, very high implied volatility. Out to September with the stock currently at 122, the 181 strike has a 10 Delta. Its implied vol is 49. In sharp contrast, the vol for a three month 10 Delta call on the S&P is 9.8.

[00:10:19] I don't believe there's ever been so wide a vol spread between a top two or three market cap stock in the S&P and the index itself. The Nvidia 10 Delta call carries an implied vol five times that of the S&P implied vol at the 10 Delta point.

[00:10:36] When the spread is enormous as it is now, implied correlation gets pushed remarkably lower. The price action in Nvidia is fascinating. Since 2023, the realized vol of the stock on days that it has risen is 55 percent. On days that it has fallen just 39 percent.

[00:10:55] The up shocks like the 16 percent move we saw in February of this year justify paying a lot of premium for out of the money calls. But from a cautionary standpoint, when a company with a three trillion dollar market cap

[00:11:09] with a double A rating generating 40 billion of free cash flow each year is moving on a 50 realized vol, it screams easy come, easy go with respect to market cap. There is absolutely a funny money aspect to it where the price action is impacting

[00:11:25] our distributions of what we expect to be possible. One further observation on how implied correlation has changed over the last couple of years, especially to the upside. Let's contrast today's super skinny 6.66 to the 10 Delta implied correlation reading of just under 50 that prevailed in late October 2022.

[00:11:46] Price came at a time when investors were very underexposed to risk, fearful of inflation, more tightening from the Fed and a stronger dollar. Thus, renting index exposure through upside call options on the S&P was popular

[00:12:00] and the vol of out of the money calls on the index was quite high back then. The pricing then was today's in reverse. Very high out of the money call vols on the S&P versus the same on the stocks in the index.

[00:12:13] The market was effectively suggesting that a large, very correlated jump in the index was possible. And wouldn't you know it, on November 10th of 2022, the S&P surged by 5.5% in gleeful response to a favorable October 22 CPI report. The market does get it right sometimes.

[00:12:33] So it's really a tale of exceptional correlations, one very high, the other quite low. The stock market and bond market are hugging each other in a way that creates diversification headaches for the 60-40 construct. But the stock market appears its own magical diversifier, at least for now,

[00:12:51] as equities are zigging and zagging, responding considerably more to idiosyncratic developments than to macro factors that typically produce higher correlation. I'm not a buyer of this continuing for an extended period of time.

[00:13:04] And with that, I am at my 2000 word limit and it's time to say goodbye for now. I wish you an excellent week. You've been listening to The Alpha Exchange. If you've enjoyed the show, please do tell a friend.

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[00:13:30] Please email us at feedback at alpha exchange podcast.com. Thanks again and catch you next time.