EQUITY RISK MONITOR HIGHLIGHTS

• Tough Week For Equities But Risk Doesn’t Budge
• Diversification Ratios High, Correlations Low

Tough Week For Equities But Risk Doesn’t Budge

The week ending April 5th saw most major equity markets down from their recent peaks as the “shadow war” between Iran and Israel caught some daylight, pushing energy prices up and US employment numbers surprised to the upside, further dimming the prospects of imminent rate cuts. China, on the other hand, continued its recent divergent streak with that market up nearly a percentage point as some reported data suggested that stimulus efforts may be working.

Risk model forecasts were largely unaffected by the performance retracement however, as predicted volatility continues to decline:

The risk vector in all these charts is pulling to the left. The return vector pulled downwards in all except China, but even there, risk forecasts are subsiding from the recent spike in early March which followed the whipsawing of January and February, in which the China-A index was down 7.7%, then up 9.9% in succession. In March the index return was a placid +65 bps.

Diversification Ratios High, Correlations Low

Two of the myriad metrics we track at the market index level in our risk monitors are the “Diversification Ratio” and the “Rolling Average Asset Correlation”. These are expected to move in opposite directions. As the diversification ratio increases, suggesting the correlations among index constituents are dropping, thereby providing greater diversification, we should also observe a decrease in the direct measurement of those pairwise correlations. 

That is what has been happening 2024 year to date, but at a somewhat alarmingly quick pace in almost all markets we track:

Once Again, only China seems to buck the trend:

In most of the Rolling Average correlation charts, the short-term trend (blue) does appear to be moving in the opposite direction from the longer-term trend (green), but there is considerable volatility in the 20-day measure of correlation so we hesitate to divine any forecast from it, although in China it is clearly an indication of the rapid return to more placid conditions after the upheaval of the first two months of the year.

In the United States market, it is worth mentioning that we have not seen the diversification ratio approach anywhere near 4 at any time in the post-COVID period. 60-day average correlations were similarly low in the 3rd quarter of 2023 (<0.2) but the diversification ratio at that time topped out around 3.7 whereas now it stands at 4.2. Gains have definitely been more widespread year-to-date, and even the notorious “Magnificent 7” has begun to splinter, with Apple, and Tesla in particular showing losses. This is likely why the apparent diversification being measured here is even stronger than last summer.