Is The Double Dip The Statistical Equivalent Of A Traffic Ticket? And Guess Which Sole Asset Class' Implied Vol Declined In The Past Month
A few days ago, BNY's Nicholas Colas was kind enough to share his perspectives on why traffic congestion and market structure are comparable, especially in the context of record high cross-asset correlations. Continuing on this series of roadside analogies, today the BNY analyst compares the economic double dip to a traffic violation, and specifically the probability of getting two speeding tickets in the span of one day. "What are the odds of being caught speeding twice in one day? One in five? One in ten? Pretty remote, one would think, given that the ratio of police to motorists on most roads is 1,000:1 or greater. I can tell you from direct and personal experience, however, that the odds of that event are much, much higher than you think. I had my driver’s license suspended for 30 days in 1997 for two tickets, issued on the same day and only a few miles apart. Here’s the thing: most people, after receiving one ticket, will drive more carefully immediately thereafter. But I, working through the math I referenced above, thought “No… The odds are actually in my favor now. I can, in fact, speed with impunity.” This proved to be an error. As it turns out, going substantially faster than the general flow of traffic will gather the attention of the law. This offsets the theoretical odds against discovery, and then some. Oh, and driving a bright yellow car. I should have mentioned that, too." And once again, the specter of market uncertainty raises its ugly head, this time in the form of spiking implied volatility, which has jumped for every asset class in the past month... except gold.
Full note from Nic Colas:
With capital markets worried about a U.S. “double dip” back into recession, today we examine what sectors/assets classes reflect the greatest amount of concern over this potential outcome. There are now scores of exchange traded funds (ETFs) – and related option chains - tracking everything from tech stocks to gold to high yield bonds. It is therefore a straightforward exercise to look at the “VIX” (the widely known measurement of “fear” related to the S&P 500) for these asset classes and industry sectors. At the top of heap in terms of “double dip” worries: tech stocks and high yield bonds. Their “VIX’s” have jumped +30% in the past month. In the middle of the pack: both emerging and developed economies outside the U.S. And not sweating the chance of a second U.S. recession: gold. The yellow metal was the only asset class to see lower implied volatility (the technical term that “VIX” actually tracks) over the last 30 days.
What are the odds of being caught speeding twice in one day? One in five? One in ten? Pretty remote, one would think, given that the ratio of police to motorists on most roads is 1,000:1 or greater. I can tell you from direct and personal experience, however, that the odds of that event are much, much higher than you think. I had my driver’s license suspended for 30 days in 1997 for two tickets, issued on the same day and only a few miles apart.
Here’s the thing: most people, after receiving one ticket, will drive more carefully immediately thereafter. But I, working through the math I referenced above, thought “No… The odds are actually in my favor now. I can, in fact, speed with impunity.” This proved to be an error. As it turns out, going substantially faster than the general flow of traffic will gather the attention of the law. This offsets the theoretical odds against discovery, and then some. Oh, and driving a bright yellow car. I should have mentioned that, too.
That is an admittedly embarrassing – but hopefully useful – allegory for the whole “recessionary double dips never happen” discussion that dominates market attention at the moment. Economic historians will (rightly) point out that two recessions back to back are relatively rare occurrences. The only one in the modern era occurred in the early 1980s, as then-Fed Chairman Paul Volker raised interest rates to cool rampant inflation. It was effectively a medically-induced coma for the U.S. economy, squashing inflation through a self-inflicted, sharp economic downturn. The first recession, just 2 years before, had been caused by the spike in energy prices created by the Iranian revolution. Aside from that doubleheader, recessions do tend to be solitary events.
However, as my bone-headed speeding story highlights, circumstances matter a lot when it comes to “unusual” events. Customarily, we don’t have double dips because consumers and businesses have some ability, and desire, to start spending again after a period of recession. They usually just need a little nudge, in the form of lower interest rates, to start buying large durable goods or perhaps take out a mortgage for a new house. That spurs employers to start hiring, and the virtuous circle of economic growth kicks into gear. The challenges to that upbeat trajectory at this point in the cycle are manifold:
- Still low consumer confidence
- Ditto for corporations
- Regulatory uncertainties that undermine hiring plans
- An unpopular President, and a doubly unpopular Congress
- A central bank that seems to have been overtaken by events. By the way, there is good fun to be had checking out Paul Volker’s old testimonies in front on Congress from the “double dip” period of the early 1980s. This was long before smoking was banned on the Hill, and Chairman Volker regularly ran through a full Churchill sized cigar while opining on monetary policy. Google Video has some of the clips online.
The last month has seen much of the “double dip” debate come to the fore, with a worsening labor market picture headlining other data reflective of a weakening economy.
In the graph that follows this note we take a look at what sectors and asset classes seem most “worried” about the chance for another recession. We take the measure of this seemingly “emotional” assessment by looking at the 30 day forward implied volatilities for the exchange traded funds associated with different industrial sectors, asset types, and U.S./foreign stock markets. Don’t be scared off – that’s just the same concept as the CBOE Volatility Index, or VIX. A higher VIX usually means more near term worries about the market. A declining VIX means investors are generally more confident that stocks will rise in the near future. A few observations:
- U.S. stocks as a whole have seen increasing IV in the past month, to the tune of 22% higher than the same time in July. That’s a sign of concern over the near term, of course, but it also serves as a useful baseline for other asset classes.
- The most notable increase in IV is actually in the option chain for the most popular High Yield Bond ETF (symbol HYG). Here, IV has actually spiked by 31% over the last 30 days, more than stocks. We hear a lot about investor complacency as it related to bond investments, but it does seem that options traders, at least, understand that a double dip might be just as bad for non-investment grade credits as it would be for stocks.
At the other end of the spectrum, and sitting in splendid isolation, is gold. The precious metal has had a pretty good month, up almost 5%. What might be more impressive, however, are the lower levels of apprehension about gold’s next move. The IVs related to the GLD ETF actually fell over the past 30 days, indicating some sentiment that gold is not heading for a fall in the near future. We see that kind of contraction in IVs when assets rise (VIX tends to go down when stocks rise, for example). But given that every single other asset class we looked at saw rising IVs versus last month, we can only look at the ‘Gold VIX” as a real sign of confidence in the metal. Or, of course, a real skepticism in everything else.
Among the major industrial sectors, technology seems to be bearing the brunt of the double dip fears. It’s IV is up 23% over the past month, more than U.S. stocks overall. Telecomm as a sector was up more, but it’s coming off a low base, and there are not many stocks in that index to begin with. No, the move higher in the “Tech VIX” really catches the eye. I confess to liking tech as a leveraged play on not getting a double dip, but my enthusiasm seem to be counter to the market’s perception that there is a lot of risk in the sector.
Interestingly, worries about overseas markets – in both emerging and developed economies – seem pretty middle-of-the-pack as far as asset classes go. The EAFE developed market ETF (symbol EFA) and the emerging market fund (symbol EEM), have seen their “VIX’s” rise by only 11% and 13%, respectively.
Full note (PDF)