Per SocGen’s real good quant team led by Andrew Lapthorne, « the use of the ‘Fear Index’ (VIX) as a predictor of future market performance has been rather mixed, with moves in VIX appearing more contemporaneous than forward looking. »
Well if VIX is not a great predictor of market returns what is ?
One answer : poor quality stocks.
In a report dated Feb 5, SocGen’s quant team has tested the idea of « looking for a pickup in volatility amongst the most highly-levered and highly-volatile stocks as a precursor to a potential wider market problem ».
Evidence tends to show that’s the case. Per SG’s report : « changes in market volatility appear to be felt first in this segment of the equity market (low quality stocks/distressed names) before it is seen through the VIX. Indeed, a high reading on this metric has historically been followed by negative equity returns… ».
Another way to look at potential rise in volatility is to look at high yield spreads. « A harbinger to near to medium term trouble, widening spreads may indicate potential market corrections while tightening may foreshadow market upsides on average. »
Over the course of 2017, HY spreads were more on the tightening trend than the widening one.
Last reading from FRED St Louis Fed Reserve data (most amazing place to look up for stats BTW), US HY spread has widened modestly, jumping from 323bp on Jan 26 to 360 on Feb 6, before falling back to 346 bp yesterday.
US HY Spread (long history)
US HY Spread (1 year history)
Both HY spreads and quality factor have some predictive power over volatility and market correction.
But there is a caveat to this analysis, as SG notes. Quantitative Easing has been a major source of distorsion in financial markets over the last 10 years or so. QE is clearly one of the major drivers behind equity market performance but also has impacted spreads, bond yields, and, yes, volatility.
The spike in volatility is a reflection of the recent « fear » in markets that with better economic prospects, inflation will be back and monetary policy will have to normalize (it has already started BTW).
But as many observers underlined, QE has actually been like a drug. Markets have been so much accustomed to it that it’s very difficult to get past it.
Every time a central banker has suggested that it might be time to withdraw the punch bowl, market reaction has been hostile. Actually, central bankers have been so afraid to provoke another recession that they would be unable to solve (since ZIRP was in full speed and there was probably nothing left to do but bailing out governments while destroying the value of money) that they have become hostage of financial markets.
Their liberation is probably the most sensible thing to do, but the process is going to be painful.