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Red alert on cross-sector correlations confirmed

Posted on 14-Sep-2011 by raisepartner

An in-depth analysis of the cross-sector correlations underlines the extreme sensitivity of today’s market conditions: a chock on any industrial sector is instantly propagated to the other sectors.

The risk alert pointed out by the RP Quant Systemic Risk Index last week is confirmed as the index continues to rise this week, remaining above its 2008 level:

To illustrate the meaning of this aggregated risk indicator, let’s look at the correlations between the industrial sectors of the Dow Jones Index and their evolution since 2006.

The surface charts below show the cross-sector correlation matrix* at 3 different dates: in the pre-2007 market conditions, at the heart of the 2008 crisis and today.

Each color stands for a given level of correlation (from blue = negatively correlated to red = highly positively correlated):

Chart 1. In standard market conditions, the cross-sector correlations range approximatively from -50% to 90%, with most values between 0% to 50% (green and yellow zones).

Chart 2. During the subprime crisis, the industrial sectors became highly dependent, with correlations ranging from 62% (orange zones) to 95% (red zones).

Chart 3. During the past few weeks, the cross-sector correlations reached a new high with a minimum value of 84%; most of the correlations are above 90% as illustrated by the dominant red zone.

Analyzing the dynamics of the cross-sector correlations confirms the unique nature of today's market regime, hence the need for investors and risk managers to define reactive systemic risk alerts.

* The DJ industrial sectors represented in the correlation matrices are the following: Basic Materials, Consumer Goods, Consumer Services, Finances, Health Care, Industries, Oil & Gas, Technology, Telecommunications, Utilities.