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Interpreting Pairwise Correlation and Dispersion of S&P 500 Stocks

Dec 10, 2018

 

  • The recent market volatility causes us to reexamine pairwise correlation and dispersion trends of S&P500 stocks to see if we notice anything that might give us a clue to the behavior of stock prices in the future.

 

Source: Capital IQ

  • The rolling 1-month average dispersion between stocks in the S&P 500 remains healthy but has moved back down and is in-line with its 2-year average. The current level of average deviation between stocks would suggest that the payoff of taking stock-specific risk, or idiosyncratic risk, is not significant today in spite of the sell-off in US stocks last week.

 

Source: Capital IQ

  • In comparison to the rolling 1-month average dispersion, the rolling 1-month average pairwise correlation has jumped up since early October and remains at elevated levels.  This would suggest, in layman’s terms, that S&P 500 stocks are moving together more closely now than there were previously.  When correlations are elevated, that implies stocks will move up together and down together in a more pronounced fashion and is typically associated with sudden sell-offs and breakouts in US stocks. 
     
  • OUR CONCLUSION: After looking at both important measures of the price behavior of S&P 500 stocks, suggests that investors would be wise NOT to take too much stock-specific risk at this time, and perhaps should pursue an investment strategy that involves combining both stocks and ETFs.