Meaningful Minutes

What is correlation? :

Let’s explain this with an example. Take two objects A and B. Every time A goes up, B rises too. And when A falls, so does B. This means B’s actions are ‘correlated’ to that of A. Now let’s replace A and B with two stock markets, economies, or even currencies. It would then mean these are interdependent. This, correlation is a statistical tool that is used to find out how a change in one variable impacts the other variable. The correlation value is usually between -1 and +1. The closer the value is to zero, the lower is the correlation.

Two types of correlation :

However, there are two types of correlation. When two variables increase or decrease in parallel, there is positive correlation. But, when one increases and the other decreases, there is negative correlation. Globally, there is some degree of correlation between stock markets all over the world. For instance, if the US market does not do well for a period of time, this poor performance is reflected across other international markets including India. However, the degree of correlation can vary between different countries.

The decreasing correlation between India and global markets :

The Indian stock markets are closely correlated to their global counterparts. However, the correlation between financial markets in India and the rest of the world has been shrinking. In April 2018, the weighted average correlation of India’s currency, stocks, and bonds with respect to global economies fell to 0.32, according to data by Bloomberg. This value is fast approaching the 10-year low of 0.29 set in November 2017. In contrast, the correlation touched its peak of 0.68 back in 2010. That said, many global factors still affect India which is not de-coupled from the world. (Understand de-coupling here.)

Reasons for the shrinking correlation :

Experts believe that this shrinking correlation is due to multiple factors. This includes: less sensitivity to global market cycles; the domestic nature of the Indian economy, and increased flow of investments from local investors. In fact, there has been a 50% rise in investments by Indian investors in mutual fund SIPs. As a result, domestic investments turned higher than global investments in the Indian markets for a third year in a row in 2017, according to a report by Quartz.

Can the correlation drop further in the future? :

The correlation between Indian and global markets has indeed been decreasing. But that does not mean India is totally distanced (or de-coupled) from global trends. When volatility pushed up bond yields in emerging countries in April, the Indian market too witnessed a similar rise in bond yields.

How to track correlation :

It’s fairly easy to track correlation. Manually, in any stock chart, you can compare the price trends of two indices, stocks or any asset price over a period of time. If you can visibly see the trend lines move in tandem, you can establish correlation. Many traders and experts, however, rely on sophisticated technical tools, which can also offer correlation coefficient data for two assets.