CHART OF THE DAY: A Measure Of Stock Correlations Suggests We May Have Just Hit A Major Turning Point In The Market

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Below is a chart of the ICJ index, which measures the implied correlation between stocks that make up the S&P 500. In other words, it measures the extent to which stocks are moving in unison.

ICJ has surged more than 25 per cent since Thursday. That is, by far, the biggest move of its kind on the index in the past few years.

chart of the day, icj index, october 2012

(You can find a technical explanation of how the index is calculated here.)

When the implied correlation rises, it’s usually a symptom of a risk-on, risk-off market environment – investors rushing to buy stocks all at once, or everyone heading for the exits at the same time.

A jump like this in the ICJ may suggest that headline-driven markets are making a big comeback.

Moreover, the ICJ has been found to have a bit of predictive power when it comes to the S&P 500 index. Research by Boston College economist Hongtao Zhou explains how:

We find a close relationship between the SPX return in the next 7 to 10 months and the current information set of SPX and ICJ weekly returns. We check the robustness of this result by resorting to 3 different sample splits and our model consistently beats the benchmark random walk model.

Another interesting finding is that the coefficient sign of the interacted term in our model is consistently positive for three different models. Intuitively, this indicates that when we observe a stock market rally or slump with a strengthened average correlation, the current market trend is most likely to continue in the future 7 to 10 months.

The study also says that “ICJ daily return volatility can be used to predict the SPX return volatility next day and the day two weeks later” – so perhaps the next few days may be bumpier trading than usual.

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