Using Volatility as a Forecasting Tool

Readers may remember a report published by our friends at Variant Perception earlier this year, entitled “Understanding Market Tops”. We presented and discussed this report in April (see: “What Makes a Market Top” for details. A download link to the report can also be found at the end of this post).

In the meantime they have published another report that has been made available to the public, entitled “Understanding Volatility”. The report focuses on how volatility data can be used to measure the degree of “herding” in the market (rising cross-asset correlations are such a sign) and how this information can be employed in making forecasts about major turning points in the stock market.

The current market situation is, in our opinion, best described as a “late bubble stage”. Due to the Federal Reserve nearly doubling the broad US money supply since 2008, financial asset prices have soared. Along with this, the credit bubble has resumed. Especially large increases have been seen in the issuance of low grade corporate debt (a.k.a. “junk”) and government debt. Combined global debt securities issuance has risen by almost 50% since 2007/2008, to more than $100 trillion. Bank credit expansion has resumed at quite a heady pace as well. The only exception to this is the euro area, where bank credit growth has declined in the aggregate in the wake of the banking and sovereign debt crisis. However, corporate bond and government debt issuance has soared in Europe as well.

Not surprisingly, volatility indicators have done what they always do in such circumstances – they have collapsed across a broad range of asset classes. 

A chart of standardized cross asset volatility from VP’s report 

This plunge in cross-asset volatility is probably best seen as a “heads-up” at the current juncture. It indicates that a time of strongly rising volatility is likely not too far away, as investors are once again underestimating and mispricing risk. However, the enormous growth in outstanding debt of almost all types indicates that risk is actually very high.

The Connection Between Debt Growth and Volatility

Variant Perception have looked at a variety of economic and financial data to find out how they correlate with stock market volatility. Based on this, they have developed proprietary indicators which provide both buy and sell signals near major turning points. What we find most interesting are their findings regarding the connection between debt growth and volatility.

Intuitively it is clear that such a connection must exist, and as VP’s report shows, this can actually be demonstrated with empirical data. Asset price bubbles are in essence a reflection of the price distortions produced by monetary pumping. These price distortions invite capital malinvestment, which is funded by credit expansion. Recessions are the inevitable reversal of this process. While additional credit expansion can always delay the day of reckoning, it cannot do so indefinitely. Additional credit created ex nihilo after all cannot not add anything to the real resources and concrete capital goods available in the economy.

Nevertheless, the process is usually preceded by a slowdown in credit expansion and the associated reversal of relative price shifts (although prices will never return to the precise configuration that was in place prior to the boom). As a rule this first unmasks economic activities that have sprung up solely as a result of the credit expansion process as unprofitable. More expensive credit and a shift in relative prices that more closely reflects the actual time preferences of actors in the economy reveals the vulnerability of such activities.

An example for this would be the bankruptcies of a handful of prominent sub-prime mortgage lending firms in early 2007. For some time, the majority of market participants believed the pronouncements of various officials that these events were meaningless and that the problems were “well contained” (interestingly, the same phrase has recently reemerged in the context of sub-prime car loans). This turned out to be an expensive error. Note that in recent years, certain sectors of the economy have once again experienced especially strong credit growth and therefore appear especially vulnerable (see e.g. one of the charts by VP we posted in the previous article on market tops).

Below is a chart from VP’s new report that shows the connection between credit growth and volatility since 1993. Credit growth in the form of commercial and industrial lending as well as commercial paper issuance is moved forward by three years and compared with the (VIX) index:

Credit growth and the VIX. Credit growth is a leading indicator of rising volatility with an approximate three year historical lead time since 1993

Not surprisingly, the VIX also exhibits an inverse correlation with the ISM, whereby the latter seems to be leading slightly prior to volatility spikes (this is to say, once the ISM enters a downtrend, it is an early warning that volatility will soon spike) while lagging slightly at turning points (i.e., the VIX tends to peak prior to the ISM making a low). In the chart below the ISM is inverted:

VIX vs. ISM (inverted)

A great number of additional charts and correlations including the VP signals can be seen in the complete report which can be downloaded here (note: registration is required, but the report is free). For readers who have missed the “Understanding Market Tops” report, it continues to be available for download as well.

Charts by: Variant Perception