Changes in U.S. equities’ behavior mean that the volatility index is an increasingly deficient barometer of market sentiment.

[This blog originally appeared on our sister site, IndexUniverse.eu.]

The US equity market’s main risk measure is back down to the levels we saw in 2007. But declines in volatility mask substantially different behaviour from stocks than pre-crisis.

The Chicago Board Options Exchange’s VIX index, commonly known as the “fear gauge”, has fallen below 15 in recent days. These are levels the index last saw in 2007, before the credit crisis erupted. VIX is shown in the above chart as the dotted red line, measured against the right-hand axis.

But another benchmark calculated by the CBOE, the implied correlation index (which, like VIX, is based on the S&P 500 index’s constituent stocks) is nowhere near 2007 levels. In fact the average internal index correlation has been on a steadily rising trend.

Rising volatility and rising correlations at the same time shouldn’t surprise us. It’s commonly accepted that when markets take a plunge, as in 2007/08, stocks move increasingly in lockstep.

You can see this in the behaviour of both VIX and the implied correlation index in late 2008, when Lehman collapsed. As VIX spiked to over 80 in November that year, the nearest-dated correlation index (January 2009) rose to over 100.

But declines in the VIX to below 20 in 2010 and 2011 and, now, to below 15, haven’t been accompanied by a fall in internal index correlation to anything near 2007 levels. In fact the implied correlation of the S&P 500’s constituent stocks is almost twice as high now as five years ago.

Two factors may be at play here. First, increased investor interest in index-based derivative products like futures and ETFs may well be causing stocks in a widely followed index like the S&P 500 to behave in a more synchronous fashion (not everyone agrees, but I think this argument makes sense).

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