Low Correlation is the Defining Risk in Markets

They say that diversification is the only “free lunch” in markets. Scatter your bets around and you’ll realize a reduction in volatility that helps you manage risk. That’s been happening at an epic scale in US equity markets: the 1m correlation among stocks in the S&P 500 is (to quote Dean Wormer from Animal House) zero point zero. But I’d argue that today’s index and the trillions of dollars that track it are enjoying a run of low correlation among stocks that is unsustainable. It’s not if, but when the next correlated risk-off episode materializes.

Effective risk management requires a healthy imagination and a willingness to carefully evaluate blind spots. In the aftermath of largescale drawdowns and spikes in measures like the VIX, a consistent realization by investors is that the degree of “sameness” in assets was underestimated. It took us until 2008 to recognize that the substantial run up in housing prices was linked to a common underlying driver: the vast supply of mortgage credit. There was a hugely under-appreciated source of correlation that failed to make it into how securities and risk scenarios were modeled. Today, amidst these record low levels of correlation among stocks in the S&P 500, are we similarly missing a hidden yet shared connection that exists in the ecosystem of companies all engaged in the pursuit of AI riches? Is the stunning wealth already generated being recycled today in the same way that mortgage credit was recycled in 2006?

I hope you enjoy this discussion and find it useful. Be well.