Take Junk over Vix
The quant team at SocGen spent last month coming up with a great new measure that could help time drawdowns of the S&P 500. It worked beautifully and would have forecast what just happened. But to the chagrin of Andrew Lapthorne at SocGen, they did not get around to publishing it until this week. Such is life.
The nub of their argument is that the volatility of low-quality (as in poor balance sheet) stocks, and the volatility of high-yield bond spreads were a better indicator of a coming drawdown than a rise in the Vix. When investors get particularly nervous about the junkiest companies in their universe, in other words, it is a sign of trouble. And indeed, when the volatility of the worst quality companies in both equities and bonds is highest, equity drawdowns tend to follow. The Vix offers no such signal.
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When interest rates rise it seems obvious that the weakest business with the greatest amount of debt should fall before the strongest. So while the initial reaction to a rise in bond yields may be to sell lower beta defensive/higher dividend yielding business, eventually as the potential pain from higher rates becomes more acute, then selling balance sheet risk and then ultimately the equity market altogether will become the greater priority. So it also seems intuitive to focus on the performance and volatility of the weakest segment of the equity market for signs of stress and not the aggregate market which is often biased toward the biggest, most profitable and usually better financed organizations. To that end, we have focused our attention on the performance of the red lines in the two charts below. The argument being that if the share prices of weak companies start falling, not only does it exasperate the problem by increasing implied leverage, but also it could be an early indication of investors becoming balance sheet risk averse.
The quant team at SocGen spent last month coming up with a great new measure that could help time drawdowns of the S&P 500. It worked beautifully and would have forecast what just happened. But to the chagrin of Andrew Lapthorne at SocGen, they did not get around to publishing it until this week. Such is life.
The nub of their argument is that the volatility of low-quality (as in poor balance sheet) stocks, and the volatility of high-yield bond spreads were a better indicator of a coming drawdown than a rise in the Vix. When investors get particularly nervous about the junkiest companies in their universe, in other words, it is a sign of trouble. And indeed, when the volatility of the worst quality companies in both equities and bonds is highest, equity drawdowns tend to follow. The Vix offers no such signal.
***
When interest rates rise it seems obvious that the weakest business with the greatest amount of debt should fall before the strongest. So while the initial reaction to a rise in bond yields may be to sell lower beta defensive/higher dividend yielding business, eventually as the potential pain from higher rates becomes more acute, then selling balance sheet risk and then ultimately the equity market altogether will become the greater priority. So it also seems intuitive to focus on the performance and volatility of the weakest segment of the equity market for signs of stress and not the aggregate market which is often biased toward the biggest, most profitable and usually better financed organizations. To that end, we have focused our attention on the performance of the red lines in the two charts below. The argument being that if the share prices of weak companies start falling, not only does it exasperate the problem by increasing implied leverage, but also it could be an early indication of investors becoming balance sheet risk averse.
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