Look! A ‘Junk Stock VIX’

If you follow SocGen’s Andrew Lapthorne, you know that he’s been pounding the table on low vs. high quality stocks for, well, for as long as we can remember which probably means “forever”.

When you hear “low quality stocks” think highly leveraged, distressed firms which, one would certainly imagine, might well be the first to “go” when the overall market begins to roll over.

Well, apparently dissatisfied with the VIX as a leading indicator (it doesn’t really work well in that capacity), Lapthorne has developed what amounts to a VIX for junk stocks.

“Logically when interest rates rise and markets and economic direction take a turn for the worst, it should be the weakest elements in the economy that suffer first,” Lapthorne writes. “So looking for a pickup in volatility amongst the most highly-levered and highly-volatile stocks as a precursor to a potential wider market problem seem sensible.”

Why yes, yes it does. As SocGen goes on to explain, “the types of stocks typically captured in a High versus low Quality equity style, the short leg of the Quality factor represents the most distressed firms and it would appear historically that changes in market volatility appear to be felt first in this segment of the equity market before it is seen through the VIX.” In other words, this thing back tests well:

Essentially, when this index is above the 66 percentile, it’s a sign of market stress and risk-aversion, while readings below the 33 percentile are signs of, well, of the opposite.

If you’re wondering whether there’s a parallel here with HY spreads, the answer is “yes.”

Here’s where the ‘junk equity VIX’ is now:

As you can see from the chart, it breached the 66 percentile on January 30. As Andrew quips, “it is a big shame given recent market declines that we didn’t manage to publish this note on a timelier basis!”

At least we’ve got it going forward.