In his book A Demon of Our Own Design Richard Bookstaber describes how the breakdown of basic market physics during Black Monday meant that “all stocks moved together” (see related posting):

“The huge volatility of the market broke down all but the most fundamental relationships between markets and securities.  The usual day-to-day world where investors cared about subtleties like corporate earnings or analysts’ forecasts dissolved as the energy of the market was turned up.  All stocks moved together; if it was a stock, it was soldit was like plasma physics: as matter becomes hotter, it becomes less differentiated.  The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms.  Turn up the heat even more and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.”

Since 1987, the term “correlations go to one in times of stress” has become axiomatic in financial markets.  But does research actually back up his common assumption?

In a January research note to clients (Stress Risks within Asset and Surplus Frameworks) available here at AllAboutAlpha.com with free registration), Morgan Stanley’s Marty Leibowitz and Anthony Bova take a good hard look at this phenomenon.  According to their report:

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