The VIX and Company Risk

Keeping with a few recent posts dealing with volatility and the market’s overall opinion on market stress, we thought it might be interesting to examine the connection between equity market volatility and market participants’ ideas on corporate risk.  

The VIX, an index that quantifies the market’s views on forward 30-day volatility, has historically been very closely related statistically to past/recent realized market volatility.  In other words, the levels of recent market volatility heavily color the market’s view of volatility in the near future.  This makes sense.  There’s a strong amount of “recency bias” among investors.  Taking the view on market volatility one step further, though, shows that percentage changes in the VIX are significantly correlated to percentage movements in Markit’s 5-year Investment Grade Generic CDX Index, which measures credit default swap prices for 125 investment grade companies across all sectors.  Higher levels in the CDX index show that the cost to insure against bond defaults in these companies is rising, meaning that the market’s view on corporate risk is increasing.  Lower levels in the index show that the market is less worried about corporate risk.  The VIX/CDX relationship is interesting, and shows the direct connection between individual company risk (or perceived risk) and overall market jitters.  

Here is a chart going back to the beginning of 2006.  Values for the VIX and CDX indices have been normalized for comparability.

Sharp rises (declines) in the VIX have been accompanied by sharp rises (declines) in the CDX index over the past decade.  In percentage terms, the moves from peak to trough have been almost completely in sync.  Accordingly, the weekly correlation for the percentage co-movements in these indices is approximately 0.65.  

We’ve obviously gotten geeky here.  What does the above chart convey in our view?

• As one would expect, stock market volatility is related to underlying corporate risk.
• Just as the realized volatility and the overall VIX index have hit multi-year lows, the market’s view on corporate risk is falling to the lowest levels since 2007.
• In 2007, the VIX and the CDX index began creeping higher nearly a year before global equity markets began experiencing significant convulsions.  
• While there are no guarantees, we’ll surmise there will be a similar deterioration in market attitudes towards risk decently ahead of the next market snafu.  
• We’ve seen this play out with deterioration in leading economic indicator indices over time.  Significant downward moves in the leading economic indicators have occurred well ahead of major market calamities.  Of note, the beginning of the move upward in the VIX and CDX indices in early 2007 coincided almost perfectly with signals from leading economic indicators that recession probabilities had increased significantly.  This makes intuitive sense that perceptions of corporate risk, and hence volatility, would increase with increased recession probabilities.  Because…What happens during recessions?  Earnings collapse and earnings volatility significantly increases.  In other words, corporate “risk” jumps through the roof.
• Therefore, while corrections, sometimes very uncomfortable, come and go, we maintain our view that a major market calamity isn’t on the immediate horizon.  As with some of the other early warning indicators we’ve discussed such as financial market stress, until we see indicators like the CDX index begin to creep higher on a sustained basis in sympathy with recession warnings, we’ll stay involved in markets.  As seen above, the CDX index is still trending down.  And, despite a noisy and discouraging Q1 GDP print in the US, leading indicators here and abroad haven’t budged to the downside whatsoever.  The probability for recession over the next 8 to 12 months remains very low.  We’ll stay vigilant though!

Complacency

A few weeks ago, we discussed the very low levels of stress showing up in the various Federal Reserve and Conference Board financial system indicators.  Digging deeper and looking at some of the individual indicators of risk-tolerance and volatility out there in various markets produces some very interesting observations.  

Since we spend our time investing in the global equity markets, we’ll take our first quick look at volatility in the S&P 500 and the MSCI EAFE equity indices.  The charts below show that market volatility is back at multi-year lows, hence explaining why the VIX in the US is trading at multi-year low levels.  We use the standard deviation for the trailing 20 days of index performance.  In the S&P 500, realized volatility has reached the lowest sustained levels observed since early 2011.  The EAFE has achieved a much more significant milestone.  20-day volatility in the MSCI EAFE hasn’t been at these levels since May 1996!   

What happened the last time volatility got this low?  The 2011 episode, of course, morphed into a massive correction and spike in volatility in August of 2011 as the European financial crisis and S&P US debt downgrade crisis took hold.  In 1996, the EAFE subsequently corrected just south of 10%, with the correction low achieved in early 1997.  The market correction lasted nearly a year.  In both of those cases, markets eventually resumed strong upward trajectories.  Prior to 2011, the last sustained round of low volatility at these levels occurred in April 2007, just before the global financial crisis began brewing.  We don’t want to make any alarming market calls, especially since many of the other indicators we follow show a much better backdrop than the environment confronting markets in April 2007.  Nonetheless, we would not be surprised to see this market take a corrective breather in the near-term.  

Our next look comes from the world of high-yield bonds.  We like to look at the spread between the Bloomberg High-Yield Index and 10-year US Treasury yields.  When this spread is trending down and compressing, it’s an indication that flows into the riskier end of the debt pool are strong and, hence, risk tolerance is higher.  This week, the spread has compressed to the lowest level observed in our data series, which goes back to 2002.  Yes, depending on the indicator, high yield spreads have now equaled or eclipsed the levels observed in early 2007 on the downside.  The global chase for yield has certainly been a formidable force.  Anecdotes in the business press continue to pour out about the reemergence of cov-lite loans and PIK bonds and the like.  

Does this mean the world is about to come to an end?  Not necessarily.  As you can see below, during the last cycle, spreads first reached super compressed levels in late 2004 and stayed benign for approximately three years before the wheels came off the debt (and equity) markets and spreads spiked to record levels.  As we mentioned above when discussing equity volatility, the general indicators we like to use present a better backdrop than observed in early to mid 2007, when indicators were clearly showing recession probabilities were high and that long-term momentum was waning in various areas across the investment universe.  But, we’ll say again, we wouldn’t be surprised if there’s some sort of corrective activity in these markets to keep participants on their toes in the near future.

We’ve said on several occasions over the past year and a half that the overall intermediate-term market backdrop remains favorable worldwide, especially in overseas markets.  There’s nothing at present that materially changes our intermediate-term view.  However, corrections are a part of life in equity markets and other markets and serve to reset investor expectations in a healthy way.  Indicators like the ones above show that a reset may be in order in coming weeks and months to recalibrate risk markets that have become very complacent.  Of course, we’ll keep an eye on the longer-term trends.  If anything changes underneath the surface worthy of changing the intermediate-term outlook, we’ll certainly shout it from the rooftops.

No Stress

With accommodative central bank policy feeding into low stock market volatility worldwide, tight corporate bond spreads, and other indications that financial market worries remain at low levels (such as report this week in the Wall St. Journal that home equity loans are becoming popular again), we thought it would be interesting to capture where current financial conditions stand in a single, clean indicator.  

As such, we used three financial system stress indices produced by various Federal Reserve branches in combination with the Conference Board’s Leading Credit Indicators Index to produce a single indicator showing that, indeed, we’re observing a period of accommodation and low financial stress that rivals the go-go financial system days of the mid-2000s.  

Quickly, how did we construct our index?  We took the 4-month moving averages for the St. Louis Fed Financial Stress, Kansas City Fed Financial Stress, Chicago Fed National Financial Condition, and Conference Board indices going back to 1994.  Then, we calculated the Z-scores (standard deviations away from average) for the 4-month moving averages in each of the indices.  Finally, we averaged those z-scores across the four indicators to produce the final indicator.  

How do organizations like the Federal Reserve Banks and Conference Board construct financial system indices?  The Conference Board, for instance, uses a variety of financial market indicators such as swap spreads, the TED spread, margin and debit balances, and national bank loan surveys to construct their index.  The Chicago Fed uses 105 different financial market indicators to construct an index, many relating to loan surveys and various interest rate and swap spreads as well.  

Here is a visual representation of the work:

As you can see financial system stress remained below average through the mid-1990s until the time of the Asian/Russian/LTCM financial crises drove financial system stress higher.  Stress remained elevated through the market turmoil and recession from 2000 to 2002.  Coming out of the early 2000s recession, financial stress declined markedly, reaching a bottom in 2005 at approximately the same time the real estate boom was nearing a peak and central bankers in the US started talking about the so-called “global savings glut.”  Stresses started to increase dramatically in mid-2007 as the markets glimpsed the first signs that the leveraged financial products markets associated with the housing boom were beginning to crack.  As the worst financial crisis since the Great Depression unfolded, we see a dramatic spike in system problems.  The highest level of stress in our indicator was reached in December 2008 near the very height of the Great Recession.  Coordinated global central bank actions pulled us back from the brink through 2009 and financial system conditions have continued to improve since then, except for a few spikes associated with the European turmoil during 2010 and 2011.  Interestingly, the lowest level ever recorded in this index occurred in February of this year.  The index isn’t far removed from those lows; financial conditions remain very accommodative.  

What are some takeaways from looking at this data?  

Over the past 20 years, the two big equity market downturns in the US and globally happened several months to a couple of years after these financial stress indices began showing bottlenecks in the system and spiked higher, well above zero.  Looking at the current market situation, while this isn’t a primary indicator we use to drive risk allocations, we think this meets up with other indicators that we use showing that the risk for a major market calamity are reasonably low at present, even though long-term valuations in the US are somewhat stretched.  For instance, leading economic indicators here and abroad show the risk of recession over the coming year remains very low.  And, general longer-term market technical indicators remain favorable.  Until we see indicators like this begin to grind noticeably higher and above the zero-line, we’ll remain sanguine about the intermediate-term path of equity market prices.  

That said, the contrarian gremlin in us notes the extreme low stress level in this index will have to unwind at some point.  Looking across markets and asset classes, it’s hard for us to see, for instance, how high-yield corporate debt spreads could get much tighter.  Granted, this index remained at extremely low levels for three or four years ahead of the Great Recession.  When benign conditions unraveled, however, the unprecedented long period of calm morphed into an unprecedented period of stress.  Just as risk and reward can be symmetrical when looking at equity markets, there’s a symmetry to indicators like this.  Big deviations to the downside tend to lead eventually to big deviations on the upside.  We’ll certainly keep an eye on this and other market indicators for signs that trends are changing.