By now, most sane market observers and participants understand that perhaps, just perhaps, everything we believed about neoclassical economics is not without fault. In fact it is possible that the entire macro-economic safety net of Keynesian policy has come into question. One look at the chart below of the changes in US financial stock prices should be enough to show that when S&P downgraded the mighty USA's credit rating, they proved the impossible is possible. The market is now entirely paranoid. Investors have fled the market in droves, as we have discussed endlessly. The banks themselves seem to question their own existence given the plunge in liquidity, and the huge rise in volatility and correlation appear to suggest the market is indeed terrified of its own shadow.
The chart shows the daily percentage change for XLF (the financial ETF). The regime change post US downgrade is simply incredible as each and every day, the slightest shift in momentum is interpreted as all-is-good or all-is-bad and nothing in between. We can only hope that all those long-only value investors have adjusted their holdings to account for the massive jump in volatility.
At the same time, market participants started to price expected (implied)correlation higher and higher (or the potential for a catastrophic event). Realized correlation is extremely high as, just like in the XLF above, the broad market is reflexively judging every rip and every dip as the end of the world or the beginning of Nirvana.