Capitalization Coupling: Major Indices at Correlation Highs

Includes: DIA, IWM, SPY
by: Michael Bommarito

Last summer, I often covered the difference in short-term performance between the Russell 2000 and S&P 500. I suggested that the VIX, as a measure of implied volatility, was a good predictor for this capitalization premium, and that claim often held up. I even went so far as to analyze the high-amplitude periods of this relationship. However, as the actual volatility of volatility has increased dramatically since last fall, my suggestions have been more and more difficult to implement.

I wanted to explore why this relationship had changed, and so I've taken a look at the Dow 30 (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY), and Russell 2000 (NYSEARCA:IWM) since 2002. The figure below shows the cumulative return of each index ETF in the top pane. The bottom pane shows the trailing 100-session percentage-correlation between each pair of indexes.

click to enlarge

One of the most striking features of these plots is that all three indexes are trading at or above their highest historical correlations on this range. The only timespan of comparable length was during late 2002 and early 2003 as a short bear market held sway.

The other relationship that caught my eye was that the trend in correlation between the indexes was inversely related to the overall market performance. In other words, as the correlation between indexes fell, the markets rose on average. Furthermore, during these falling correlation periods, the Russell often outperformed its counterparts, and vice versa in rising correlation periods. This relationship likely reflects the fact that the capitalization premium and discount on small caps and large caps is very much a function of the strength of the economy and credit market.

In the future, I'll be watching closely for a decline in the correlation between these indexes as a confirmation of overall market uptrend.