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The unusually low level of stock market volatility has drawn widespread attention recently as the crowd tries to decipher what it means for equity investing and the economy. One of the interpretations is that low vol is a sign that recession risk is low. That’s true, at least at the moment. But the historical connection between market volatility and the business cycle is too unstable for drawing general lessons about recession risk. In other words, it’s dangerous to assume from volatility alone that the near-term outlook for the US economy is rosy. The opposite is true too: a spike in vol by itself doesn’t always signal a new recession.
I’m not suggesting that business-cycle risk is rising. In fact, the numbers suggest the opposite these days, based on a broad measure of key indicators that track the macro trend. Data that’s been published since that update late last month also point to low recession risk. Notably, last week’s employment report for April looks encouraging; ditto on the outlook for a rebound in Q2 GDP growth.
The upbeat state of macro at the moment is almost certainly a factor that’s keeping stock market volatility low. The VIX Index, for instance, which measures the implied volatility on the S&P 500 via index options on the benchmark, dipped this week to its lowest level since the early 1990s.
“We have a uniform belief that the economy can indeed handle a couple of rate hikes, and maybe they’d even be good for business, particularly for the banks,” says Jim Cramer, the host of CNBC’s Mad Money. “It’s pretty amazing that investors welcome rate hikes rather than fearing them. That is just a fear-killer.”
The extraordinarily calm profile via market vol has unleashed a torrent of analysis lately in search of deeper meaning. One of the discussions that’s become topical is the question: What could drive the VIX higher? Market history tells us that a spike in vol is usually associated with a drop in the stock market.
“As ever, it all comes down to one thing – the business cycle,” Raoul Pal, an independent investment strategist and publisher of the Global Macro Investor newsletter, tells Reuters. “The VIX is not going to rise significantly until the business cycle weakens, nor is the generalized level of volatility.”
Perhaps, but there’s a limit to that reasoning, according to the historical record. Sharp increases in the VIX don’t always accompany new US recessions, as defined by the NBER. In August 1998, for instance, the VIX doubled from its June reading to a then-record-high of 44 without leading to a recession. More recently, the VIX has surged while the economy, although wobbly at times, remained on a growth course.
The most recent example: August 2015, when the VIX spiked up to 40 midway in the month from just roughly 13 a few days earlier. In subsequent months there was concern that the economy was slipping into a recession. But as we now know, the US trembled but never succumbed to an NBER-defined downturn. Even by the following February there was a “lack of a clear-cut recession warning in The Capital Spectator’s proprietary business-cycle benchmarks,” as I noted at the time.
The lesson is that spikes in market volatility are unreliable for monitoring recession risk. That’s hardly a surprise since it’s long been established that Mr. Market’s gyrations aren’t perfectly aligned with the business cycle. Indeed, a markets-based reading of economic risk appeared to signal a new recession was imminent in early 2016. The warning was wrong, of course, offering another validation of Paul Samuelson’s famous quip that the stock market has predicted nine of the last five recessions.
The limits of using the stock market for business-cycle analysis are no less relevant for the VIX and market volatility in general. Vol and return, after all, are really two sides of the same coin. If one side has serious flaws for estimating recession risk, the caveat applies to the other too.
Consider that in August 2015, Goldman Sachs issued a report that implied that a new recession was imminent based on a sharp rise in the VIX. By that definition, the near-term future looked dark from a business-cycle perspective. But the signal is usually impaired by a fair amount of noise, which turned out to be true in that case.
Keep in mind, too, that a relatively low VIX is no assurance that a recession isn’t near. That’s usually the case, but there’s been one exception in the VIX’s three-decade history. Market volatility was falling going into the 1990-1991 recession, dipping to a comparatively tame 15.5 in June 1990, on the eve of the downturn. That was down from 25-plus at the start of the year. For anyone looking at the VIX alone, the market calm was misleading for reading the business-cycle tea leaves.
Don’t misunderstand: stock market activity is a useful input for modeling the business cycle, but only – and this is critical – in the context of a broader set of economic indicators. Yes, Mr. Market’s macro warnings can be timely – sometimes. But they’re often wrong when it comes to looking for new recessions. The same can be said of trying to divine reliable business-cycle signals from the VIX. Why? Markets decline for any number of reasons, and faltering economic growth is only one of several possible catalysts.
Another recession is lurking in the future, although there’s no sign of trouble at the moment. But that’s no excuse to let your guard down. Real-time monitoring is essential for developing statistically robust warnings that are also timely. But the devil’s in the details, which is to say that how you look for new recessions is every bit as important as remaining vigilant.
The bottom line: You should look well beyond Mr. Market’s gyrations for developing reliable real-time estimates of recession risk. Accordingly, don’t assume that a future spike in VIX by itself is a sure sign that that US economy is slipping over to the dark side.