Market Correlation Index

I developed what I'm calling the "Market Correlation Index" to identify the average level of correlation between the different market sectors.

The red line indicates the average market corellation, the higher its value the more correlated the different sectors are.. The gray line shows a normalized version of the general market level (normalied so that the maximum over the time period is 1.0 and the minimum is 0.0).

This index is more of a short term indicator that can be used to help identify the end of a multi-day or multi-week moves in the market. As with all indicators, it should be used in conjunction with other information in making decisions.

I consider this index to be somewhat of an "irrationality gauge" in the same way the VIX is generally considered to be a "fear gauge". When panic sets in and people are indiscriminately selling everything the index will generally rise. As people become more rational and start to pick and choose what they are selling and/or buying the correlation index should reverse course and go down.

History

The following graph shows the market correlation index compared to the closing price of the SPY ETF (essentially the S&P 500 index):

This graph shows data from February 1, 2005 to January 29, 2009. I haven't yet done a thorough examination of this indicator, however just in looking at this graph it appears to be more useful at times when the market is making wild moves compared to when it is just doing the 'usual' gyrations.