Misinterpreting Volatility, Economic Edition

The recent volatility has not only given some investors pause, it caused economists and academics to speculate and ruminate on what it might foretell about the economy. Which the media has now picked up on, spinning the yarn that investors' concerns about volatility would beget a weaker economy, in turn creating more volatility for markets. While stocks are a forward-looking economic indicator, they aren't perfectly rational in the short-term. Volatility is often just markets being markets. It doesn't necessarily reflect economic conditions, much less create them.

Many see the latest round of swinging stocks as evidence the weak global economy is entering a new and more uncertain stage, including monetary policy shifts that might conflict, slowing growth in pockets of the globe and even health fears. They point to recent sharp shifts in the Chicago Board Options Exchange's Volatility Index (VIX)-which surged to a 28-month high last week, then plummeted at least 10% per day on October 16, 17 and 18-then rose the same amount the following trading day.^[i] Many see the VIX as the uncertainty index-"The Fear Gauge." (Nevermind that this is a fallacy, because the VIX merely attempts to measure the magnitude of future moves, not the direction.) The presumption is that with rising uncertainty/fear/VIX comes a near-inability for businesses to plan for the future.

The Kansas City Fed added some academic firepower to the issue, too. They published a paper September 4, suggesting spikes in uncertainty slow growth and hiring. The VIX is their uncertainty gauge, and they wag an accusatory finger at the sharply rising readings in 2011, 2012 and 2013. Hiring, they found, slowed during the volatility. They argue the effect didn't go away as fast as the VIX fell, suggesting to them a lingering fear that weighed on the economy. In theory, uncertainty is bad for business and stocks. So you might presume there is some underlying truth to the notion today.

But it is flawed logic to take the VIX's swings (or a stock index's for that matter-no reason to necessarily select the VIX here) and presume they are signs of high uncertainty facing businesses, dampening hiring or investing. First of all, this presumes there is some "right" or "natural" level of growth or employment gains we should see, if it weren't for those darned volatile markets-a fallacy. But even if we overlook this logic-test fail, maybe-just maybe-it isn't the VIX that's driving all this? Maybe businesses got caught up in the story du jour. After all, the VIX usually doesn't swing in a vacuum. There is generally some fear-based headline when volatility runs high. Like the fears the eurozone would fall apart in 2010 or America may default in 2011. But then again, if we assume they get caught up, how can we know when the fears pass and things are "normal" again? Not to be redundant, but there is no normal rate of hiring or growth. There might be averages or medians, but these are mathematical functions of long lists of results, some bigger than the average, some smaller. And why would volatility-cancelled hiring linger long? If this theory were true, wouldn't it merely push some demand for labor back, resulting in bigger hiring surges when calm returns?

Business decisions are very likely predicated on the actual business conditions specific firms encounter. If the business we're talking about is now-defunct Borders Books, we don't think market volatility really affected their capex and hiring plans a few years back. Beyond that, sentiment-driven movements are fueled by investors' feelings at the time, which may be wholly unrelated to business conditions. And feelings change! The VIX can flip from reflecting heightened uncertainty to reflecting more certainty rather quickly (as it has lately). What should an interpreter make of that, economically? Conditions on the ground likely didn't deteriorate and rebound with the speed of the VIX. Actual uncertainty didn't morph that fast. What, also, should one make of heightened volatility in 1998, mid-1999, 2003 or 2006? Searching for economic fallout from stock market wiggles presumes markets always rationally register future economic conditions. But most market observers can see the fallacy here. Consider: Every bubble in the history of bubbles. Or the extreme pessimism common to market bottoms. As legendary investor Ben Graham put it, "In the short run, the market is a voting machine but in the long run, it is a weighing machine."

Stocks are a useful gauge of future economic conditions, but it's a mistake to take every wiggle at face value and assume the economy slows ahead, justifying the market dip and potentially causing further downside. Many dips have no rational justification. To better differentiate between noisy bouncing, in our view, you must take a longer-term view and assess the gap between sentiment and fundamentals. Today, The Conference Board's Leading Economic Index (LEI) is high and rising, up again in September-the seventh rise in this year's nine readings-this time by 0.8% m/m. All but one component rose. New orders in the ISM's Purchasing Managers' Indexes have been expanding since June 2013. New orders for core capital goods-a proxy for business investment-are at their highest level since records began in February 1992. Businesses are investing, profitable and sitting on huge cash piles-fuel for more spending ahead. We'd humbly suggest the current volatility looks more like noise than a signal of economic problems to come.

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