Correlations between Major Stock Indexes and their respective Volatility Measures – Google Bard interprets!

 

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Sid: The accompanying table displays the correlation between major indexes and their volatility indexes as measured by the CBOE. Notably, the Dow 30 is a subset of the S&P 500 and exhibits a moderate correlation coefficient of 0.680. However, their respective volatility indexes, VIX and VXD, display a remarkably high correlation of 0.957. This apparent discrepancy begs the question: what is the explanation behind it?

Bard: The discrepancy between the correlation coefficients of the Dow 30 and S&P 500, and their respective volatility indexes, VIX and VXD, can be explained by the following factors:

• The Dow 30 is a price-weighted index, while the S&P 500 is a market-cap-weighted index. This means that the Dow 30 is more sensitive to changes in the prices of its largest constituents, while the S&P 500 is more sensitive to changes in the prices of its most widely held constituents. As a result, the Dow 30 is more likely to be volatile than the S&P 500, even if the two indexes are moving in the same direction.
• The VIX and VXD are both measures of implied volatility, but they are calculated using different methodologies. The VIX is calculated using a basket of S&P 500 options, while the VXD is calculated using a basket of Dow 30 options. This means that the VIX and VXD are not perfectly correlated, even if they are both measures of implied volatility.
• The correlation between the Dow 30 and S&P 500 has been declining in recent years. This is likely due to the increasing diversification of the S&P 500, as well as the growing popularity of passive investing strategies. As a result, the VIX and VXD are becoming more correlated, as they are both more sensitive to changes in the overall level of volatility in the market.

In conclusion, the discrepancy between the correlation coefficients of the Dow 30 and S&P 500, and their respective volatility indexes, VIX and VXD, can be explained by a number of factors. These factors include the different weighting methodologies used by the two indexes, the different underlying options baskets used to calculate the VIX and VXD, and the declining correlation between the Dow 30 and S&P 500 in recent years.

Sid: That was an excellent explanation. Although some high market-cap Nasdaq stocks are also in the S&P 500, the majority of Nasdaq stocks aren't, despite sharing a high correlation of 0.969 with the broader market index. Additionally, VIX and VXN, their respective volatility measures, are also highly correlated. Is this a coincidence or by design?

Bard: Thank you for the compliment. I'm glad you found my explanation helpful.

The high correlation between the Nasdaq 100 and the S&P 500 is not a coincidence. The two indexes are both market-cap-weighted, which means that they are both more sensitive to changes in the prices of their largest constituents. Additionally, the Nasdaq 100 is home to many of the same high-growth technology companies that are also in the S&P 500. As a result, the two indexes tend to move in the same direction, and their respective volatility measures are also highly correlated.

The high correlation between the VIX and VXN is also not a coincidence. The two indexes are both measures of implied volatility, which means that they are both sensitive to changes in the expectations of market participants about future volatility. As a result, the VIX and VXN tend to move in the same direction, and their correlation coefficient is typically around 0.90.

So, to answer your question, the high correlation between the Nasdaq 100, S&P 500, VIX, and VXN is not a coincidence. It is due to the fact that these indexes are all sensitive to the same factors, such as changes in the prices of large technology companies and the expectations of market participants about future volatility.

Sid: Although the correlation between the Nasdaq and Russell 2000 indexes is low at 0.184, their volatility measures show a significant correlation with VXN and RVX at 0.778. Can you explain this lack of coordination?

Bard: Sure, I can explain this lack of coordination.

The Nasdaq 100 and Russell 2000 indexes are composed of different types of stocks. The Nasdaq 100 is a technology-heavy index, while the Russell 2000 is a small-cap index. As a result, the two indexes tend to move in different directions, especially during periods of market volatility.

For example, during the COVID-19 pandemic, the Nasdaq 100 index fell by about 30%, while the Russell 2000 index fell by about 50%. This was because the technology sector was relatively less affected by the pandemic than the small-cap sector.

The volatility measures of the two indexes, VXN and RVX, are more correlated because they are both measures of implied volatility. Implied volatility is a measure of the market's expectation of future volatility. As a result, VXN and RVX tend to move in the same direction, even if the Nasdaq 100 and Russell 2000 indexes are moving in different directions.

In conclusion, the lack of coordination between the Nasdaq 100 and Russell 2000 indexes is due to the fact that they are composed of different types of stocks. However, the volatility measures of the two indexes are more correlated because they are both measures of implied volatility.

Sid: As expected, the S&P 500 and VIX, Dow 30 and VXD, and Nasdaq and VXN have high negative correlations. However, the Russell 2000 and RVX share a moderate negative correlation of -0.505. Can you explain this?

Bard: Sure, I can explain this.

The negative correlation between the S&P 500 and VIX, Dow 30 and VXD, and Nasdaq and VXN is expected because these indexes are all inversely related to volatility. This means that when the stock market is doing well, the VIX, VXD, and RVX will be low, and when the stock market is doing poorly, the VIX, VXD, and RVX will be high.

The moderate negative correlation between the Russell 2000 and RVX can be explained by the fact that the Russell 2000 is a small-cap index, and small-cap stocks tend to be more volatile than large-cap stocks. As a result, when the stock market is doing poorly, the Russell 2000 is likely to fall more than the S&P 500, and the RVX will be higher.

However, the correlation between the Russell 2000 and RVX is not as strong as the correlation between the other indexes and their volatility measures. This is because the Russell 2000 is not as sensitive to volatility as the other indexes.

In conclusion, the moderate negative correlation between the Russell 2000 and RVX is due to the fact that the Russell 2000 is a small-cap index and small-cap stocks tend to be more volatile than large-cap stocks. However, the correlation is not as strong as the correlation between the other indexes and their volatility measures because the Russell 2000 is not as sensitive to volatility as the other indexes.

Data Sources: Yahoo Finance

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