What Is the Economic VIX? -- Journal Report

08/08/2020 | 07:14am

By Simon Constable

Many investors are familiar with the VIX, or volatility index, that measures how much investors expect to see the S&P 500 index fluctuate.

But far fewer know even a little about a measure of volatility in economic growth called the Economic VIX Index, created by Jim Paulsen, chief investment strategist at investment-management and research firm Leuthold Group. The Economic VIX is important now because its history over the decades since World War II shows that stocks do best when economic volatility in the U.S. is at its lowest or its highest -- and the pandemic is stoking economic volatility that Mr. Paulsen believes will be historic.

"Over the next four quarters we'll have a level of economic volatility never before seen in the postwar period," Mr. Paulsen says. "It will blow away the volatility" of the 2007-09 recession, when the Economic VIX shot up to its previous postwar peak.

Growth in U.S. gross domestic product is expected to hit an annualized rate of 15.2% in the current calendar quarter, then drop to 6.8% in the fourth quarter and 5.8% in first quarter of next year, according to the results of the Wall Street Journal Economic Forecasting Survey -- the kind of big swing that pushes the Economic VIX higher.

Here's what that could mean for stocks: From 1950 to 2020, when the Economic VIX was within its highest quartile for that period, the S&P 500 averaged annualized total returns of 21.2% over the next quarter, Leuthold's analysis shows. When the Economic VIX was within its lowest quartile, returns averaged an annualized 16.6% over the next three months. When the Economic VIX was within its two middle quartiles, annualized returns for the following quarter averaged 6.5%.

Over those seven decades, the Economic VIX ranged from roughly 0.2 to 3.4. (The index represents the standard deviation of quarterly annualized percentage changes in U.S. nominal GDP over the previous three years divided by the average annualized quarterly growth rate over those three years.) Mr. Paulsen expects the index to reach 13 in the coming months. Given the historical performance of stocks during periods of high economic volatility, that should make this a good time to invest in stocks, he says.

But why do stocks perform so well when economic growth is highly volatile? "High Economic VIX signifies that the economy is in an unsustainable situation and everyone is working to improve it," Mr. Paulsen says. The government typically rolls out emergency measures to help stabilize the economy, as both Congress and the Fed have during the current crisis. "Policy officials are scared to death, and they are bringing every conceivable tool they have to get us out of the situation, " Mr. Paulsen says. Meanwhile, companies cut costs and improve their finances. Those government and corporate efforts are "a powerful combination for growth," he says, and that tends to be good for stocks.

Another factor, Mr. Paulsen says, is that investors tend to pull money out of stocks as the economy begins to waver, as they did in the bear market we saw earlier this year. But eventually that accumulation of cash in investor hands builds to a point where it becomes powerful fuel for a potential market rebound, like the one we've seen over the past few months.

Mr. Constable is a writer in Edinburgh, Scotland. He can be reached at reports@wsj.com.

 

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