The indicator I’m examining this week is the Cboe 3-Month Implied Correlation Index (Cor3M). It’s the market’s expectations for how correlated stocks will be over the next three months. The Chicago Board of Exchanges calculates this measure by comparing implied volatilities (IV) of S&P 500 Index (SPX) options to those on individual stocks in the index. I have the Cor3M data since 2010, and the recent reading is its lowest ever.
Taking the index at face value, it tells us traders are expecting company-specific news to drive stocks, which should be good for stock pickers. Since correlation typically rises when stocks pull back sharply, it could mean traders see very little chance of a crash. A contrarian analysis could interpret the ultra-low Cor3M reading as complacency, which increases the potential of a pullback.
For the rest of the article, I’m leaving aside the narrative and looking directly at the numbers. Let’s find out if a low Cor3M is typically followed by bullish or bearish stock returns.
Ultra-Low Correlation Index
For this study, I went back to 2010 and separated the dates into seven buckets based on the reading of the Cor3M. I made it so that each bucket had an equal number of dates. The first bucket were the lowest readings, which ranged from the recent all-time low reading of 7.2 to 19.6.
The first table below summarizes the SPX returns for various time frames after Cor3M readings were in this ultra-low bucket of readings. The second table shows returns in other times for comparison. The SPX underperformed slightly in the shorter term but then outperformed slightly in the longer term. The percentage of positive returns was greater in each time frame when the Cor3M had a very low reading. The low readings indicate low volatility environments, as the average positive and negative were lower in magnitude at every timeframe.
This next table focuses on the three-month forward returns of the SPX. It shows the seven buckets of Cor3M readings that I used. The lowest readings (our current environment) are the top row of the table. As you go down the table, it shows returns after higher readings.
The SPX easily performed the best when the Cor3M readings were highest. When the Cor3M reading was above 57.3, the SPX averaged a return of 6% over the next three months. The next best bucket was the third one down (Cor3M between 30.4 and 37.2) averaging a return of about 3.2%.
The lowest readings, where we are now, show a 2.65% return over the next three months, which falls somewhere in the middle of the buckets. The 5.2% standard deviation of returns is the lowest of all the groups.
