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Equity Risk Monitors — February 28, 2023

Equity Risk Monitor Highlights | Week Ended February 24, 2023

Risk Forecasts down again BUT:

  • Return Dispersion trending down
  • Correlation trending up

Risk Forecasts still trending down

The week ending 24 February was the worst week of the year for US stocks thus far, with the STOXX USA 900 down 2.75%.  Other equity indices also fared poorly, with the STOXX Emerging Markets 1500 down 1.65%, the Global Developed 1800 ex-USA down 2.40%, and the STOXX Europe 600 down -1.41%.  Despite these selloffs, most risk models forecast lower index volatility than the prior week, continuing a monthslong trend:

Almost all models in all geographic regions showed lower predicted risk (there were some exceptions but the increases from the previous week were very small).   Risk models are sensitive to the “memory” parameters, such as the exponential decay used in estimating the covariance matrix of the factor returns.  Even the shorter horizon models, which have effectively “half the memory” of the medium horizon models and therefore weigh more recent returns more heavily, did not react much to last week’s selloff.  Nevertheless, there are other indicators that would point to an increase in systematic risk that should find their way into the models soon in the form of increased factor volatility and correlation:

Return Dispersion trending down

Correlation trending up

When return dispersion is down (meaning the spread between the best- and worst-performing stocks is lower), return correlation generally increases and that has also been the case:

It’s worth pointing out that the levels of correlation differ greatly between these different markets, with the United States being the most correlated on average, with 60-day levels at about 36% and 20-day levels at about 32%.  The Emerging Markets index shows 60-day levels of 4% and 20-day levels of 5%, although climbing quickly.  Developed Markets ex-US are similar in diversification to Emerging Markets, while Europe is higher, but not quite as high as the USA, implying that the Asian developed markets are less correlated (which is not surprising, given the vast difference between, say, Japan and Australia).    While average stock volatilities are generally higher in Emerging Markets, and fairly similar elsewhere, it is this relative lack of diversification in the United States that has kept US index risk levels so high for the past year.