Analysis indicates that the current level of internal correlation among US stock sectors is lower now than at any time except just before the 2018 volatility spike and subsequent market plunge. The VIX has retreated back below 20—a remarkable feat considering an active war in the Middle East and the effective closure of one of the world's most critical commodity shipping routes.
While there may be a degree of complacency in the market, it has not yet reached the levels seen from 2017 to early 2018. During that period, the VIX hit historic lows, falling below even the levels seen before the 2006 financial crisis and those during the mid-1990s US economic boom.
A key metric for gauging complacency and macroeconomic fragility is sector correlation. Overall, both the average pairwise correlation among S&P 500 constituents and the correlation between S&P 500 sectors and various factors (based on Bloomberg's primary tracking factors) are currently at levels only lower than those seen just before the outbreak of "Volmageddon"—the sharp volatility surge in early 2018.
This is particularly anomalous given the current macro backdrop. Common geopolitical and economic drivers, such as energy shocks, would typically push correlations higher, yet the opposite is occurring.
Looking back at 2017-2018, the macroeconomic environment was stable, interest rates remained near zero, and shorting volatility via inverse VIX ETFs like XIV and SVXY was popular. As volatility declined, speculators had to increase their short positions to achieve the same return for each point drop in the VIX.
While such ETFs are no longer popular today, it does not mean short volatility positions have disappeared—they exist in other forms: systematic strategies selling put options, risk parity strategies, and volatility dispersion trades, among others.
In 2018, short volatility trades became increasingly crowded until a清算 moment arrived. On February 5, 2018, US stocks fell 4% in a single day, causing the VIX to spike and triggering massive covering of short volatility positions—related ETFs were forced to rebalance before the close to maintain target exposures. The VIX briefly surged above 50 intraday.
Structurally, the index volatility (VIX) equals the product of average single-stock volatility and the correlation coefficient. Therefore, even if individual stock volatility is not low, low correlation can suppress the VIX.
This is the current situation: although single-stock volatility remains elevated, the VIX continues to decline as correlations fall. However, this reveals a clear fracture point:
Should a shock occur—whether exogenous or endogenous—correlations would quickly spike, driving the VIX sharply higher and making stock prices far more susceptible to large, disorderly declines.
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