JP Morgan’s equity derivatives team highlights a bubble not necessarily in an asset class, but in the relationship between stocks right now.
Essentially, everything seems correlated more than it was before, and this has resulted in many observers declaring stock picking dead.
They blame this correlation on the boom in ETF investing and high frequency traders, but believe that this ‘correlation bubble’ will break down.
The current correlation environment is similar to that in the second quarter of 2003, when the market started recovering from the high macro-volatility period of 2001-2003. During the early stages of the 2003 recovery, implied correlation was still high and sharply declined over the next two years.
Can investors take advantage of this and short the correlation bubble? Sophisticated options investors can, according to JPM’s team.
They recommend selling one- to two-year implied correlation on the S&P 500 — largely because at current levels of about 80 per cent, implied correlation can’s really go much higher.
Or as they say, “it’s essentially a free call option on the market recovery.”
Correlations can’t last forever, for the simple reason that different companies will have different futures. Some will go bust, some will succeed, etc., and all stocks can’t go in the same direction forever. We wouldn’t be surprised to see some ETFs out there become completely broken as well, which could open up some opportunities for investors to short as well.