Volatility and the VIX Vapors: A Lookback from 1997

We look at VIX spikes from the late 1990s TMT bubble across a stretch where the drivers include a variety of underlying threats of ranging magnitude.

Aug 06, 2024

Quick healing likely but keep supply available…

The latest VIX spike brings a lot of theories on “the why” as we try to distinguish which match lights the fuse (bad payroll, ISM, Buffett selling Apple, etc.) and what lies at the end of the fuse in terms of munitions (mass death as in COVID, credit contraction as in the credit crisis, consumer stress in mortgages, revaluation of asset pools, layoffs in major industries, panic selling such as the Japan carry trade, etc.).
The latest whipsaw strikes us as one of the smaller piles of explosives at the end of the fuse since it is not a systemic threat to the financial system like most prior VIX spikes and is not a widespread case of risk aversion but more about a narrow range of financially viable mega-cap names (contrasting with the not-so-viable bleeders of the 2000 tech bubble implode-a-thon).
Excessive sector valuations in equities and extreme credit spread compression are hardly new cyclical events across time. We have seen them before.
Worries over demand and/or supply side risks will get revisited after the election as more catalysts line up ahead of the inevitable contraction that we see every cycle (that is why they call them cycles).

The above chart runs across a range of VIX spikes over the years and cycles. We use the closing price, so it is important to note that the intraday swings can be far more dramatic. Yesterday’s example was an intraday 65 high while closing under 40.

The historical timeline provides some frames of reference and are worth a recap as the market plays through this latest bout with so many mega caps trading at market caps like a mid-sized nation. The easy part of the tension relief is that credit markets are not the problem, the industry valuation stress in equities is spread across major companies. These companies (e.g., Mag 7) are clearly financially viable even if you see their valuation parameters as bubbly and vulnerable to reassessments of the underlying assumptions. Those revaluation risks run from multiples to revenue/earnings growth.

The wild rides in VIX over the years can be tied back to many different critical drivers. The biggest and most worrisome movers are tied into systemic risks that could inflict harm on the banks all the way down to the industry and issuer level. The VIX moves can include visibility to a transmission mechanism that brings any combination of credit contraction or sovereign stress that infects the banking systems and triggers collateral and counterparty risk. There is no shortage of stories over the past three decades on what can go wrong.

VIX spikes can also be tied into amorphous generic factors with the term “risk aversion” capturing what unfolds in some markets. That can drive very real performance pain in the over-the-counter (OTC) debt markets such as risky credit (HY bonds, loans, etc.). That is also when outflows or even just the fear of outflows can drive “slow-down bids” on limited size and serious impairment of secondary liquidity. That is, mark-to-market pain rises.

Timeline lookback…

We highlight a few of the VIX spikes from the chart above to offer up some compare and contrast:

October 1998: This was a scarier period than the 45.7 VIX might indicate. This had numerous causes with the biggest triggers being the LTCM crisis, the Russia default of the summer, and fears of EM contagion. Lehman was also very much in the rumor mill as facing funding pressures and difficulty in rolling its short-term debt. The LTCM and Lehman worries were critical if the market was to avoid more balance sheet downsizing that would further roil securities and collateral values.
The Fed organized a private sector bailout of LTCM by a group of banks and brokers in September (“When Genius Failed” is a classic book on the topic). The FOMC also eased into the fall to relieve the pressure. The LTCM crisis was able to shine some light on counterparty risk and bank system interconnectedness. As the later structured credit and mortgage crisis demonstrated, the tendency to take unlimited counterparty risk only got worse. The 1998 lessons were not learned and were multiplied many-fold in the housing bubble and structured finance boom.
The 2001-2002 risk aversion: 43.7 in Sept 2001. 45.1 Aug 2002. The Sept 2001 VIX spike had a terrorist attack (across the street from where I lived), but there was more going on than that in the markets in 3 years of brutal NASDAQ and HY performance. The period saw bad behavior effects linger after the tech TMT bubble popped with Enron in late 2001 and WorldCom in the summer of 2002. Other headliners included the infamous Tyco turmoil. Fraud and low confidence in accounting/reporting standards and underwriter due diligence was rampant (see Greenspan’s Last Hurrah: His Wild Finish Before the Crisis 10-30-22).
I learned how bad the confidence factor in auditors was over time when I was later invited to present at a Swiss insurance offsite (the conference center was built into the side of the mountain. The legal claims risk must have been high!). The purpose was to talk to auditor clients (legacy “Big 8” types, etc.) about being on the lookout for fraudulent behavior. The cycle saw the death of the iconic Arthur Andersen for various reasons tied to the audits of names like Enron and WorldCom among others. As a former CPA in the early 1980s at what was then one of the Big 8 (an outdated 1980s term) working on a few Drexel clients, it was a bit of a flashback on accounting treatment questions. The summer of 2002 saw a wide range of plunging BBB bonds as industries were painted with a roller not a brush. That was notably the case in TMT.
Nov 2008: The spike to 80.1 in Nov 2008 needs little explanation. Counterparty risk exposure and bank interconnectedness risk was other worldly (see Wild Transition Year: The Chaos of 2007 11-1-22, UST Curve History: Credit Cycle Peaks 10-12-22). The period was financial Armageddon even if more than a few clueless revisionists in Congress try to redefine the period as a bailout of Wall Street and billionaires at the expense of Main Street. If the domino bank failures unfolded, Main Street was closed. Employment would have made Hoover “lessons learned” a daily event.
The sovereign crisis across 2010-2011: The 45.8 VIX in May 2010 came with Greece headlines and was the start of some multiyear waves of sovereign and bank system fear that periodically caused markets to worry about a relapse back to late 2008 as the downside scenario. The summer and fall of 2011 (VIX at 48 in August 2011) was the panic peak. Greece lit the fuse in 2010, but the market was looking past Greece to what could unfold in the major Eurozone lineup (notably Italy and Spain) or even potentially cause the relatively young € currency (Jan 1999 birth) to set off counterparty risks and asset-liability imbalance across more banks. The death of the Eurozone was on the bear vs. bull, point-counterpoint circuit. The credit rating agencies took a lot of heat for downgrades when the reality was that they really did not have much history to lean on for viable rating criteria for high income nations borrowing in “their own” common currency (vs. EM nations borrowing in US dollars).
The idea of even one country in Europe reverting to its legacy currency was a field day for bear scenario spinning. The backdrop calmed down after a period of unfortunate labeling of “PIIGS” (Portugal, Italy, Ireland, Greece, Spain). The summer of 2011 brought even more tension as the US Congress threatened default on the debt ceiling and brought a US downgrade by S&P. That cascaded into a VIX spike to 48 and lagging effects continued into a US HY peak spread in early Oct 2011. The sovereign stress was essentially over by July 2012 (“Whatever it takes” by Mario Draghi).
Summer 2015: VIX at 40.7. The summer of 2015 on through 1Q16 was so heavily colored by the collapse of the oil and gas sector that it is easy to forget the fears around China’s stock market “near crashes” in July 2015 and what that might mean for global market risks. International econ statistics stayed weak into August 2015 and set off some volatility waves that eventually subsided by the fall. The VIX can move around quickly, and the late Aug 2015 spike came after a rise off lows that had followed the July 2015 China crash noise. ZIRP came to an end in Dec 2015, so this was a busy period across the markets. We note those ZIRP periods in the chart above as the FOMC had to try to restock its fed funds toolbox for later days. Those days came with COVID.
Employment was on the rebound in 2015-2016, so Trump inherited a strong rate of jobs growth. The average payroll growth in Obama’s second term was higher than Trump in his pre-COVID period. We had earlier addressed the employment histories and what that means for the consumer sector backdrop (see Employment Across the Presidents 8-15-23). From that earlier piece: “After Obama added 2.58 million jobs per year in Obama II, we see Trump add 2.1 million jobs a year for the first 3 years before the bottom fell out with COVID. In other words, Trump added jobs at a slower annual rate in his first 3 years than Obama did in his second term.” That is a seldom mentioned fact when discussions turn to the “Greatest Economy in the History of the World” (see Presidential GDP Dance Off: Clinton vs. Trump 7-27-24, Presidential GDP Dance Off: Reagan vs. Trump 7-27-24).
Feb 2018 and two 1,000-point Dow drops: With Trump citing the “Kamala crash” yesterday, he should fact check his own history given the two 1,000 point drops in the same week in early Feb 2018. Trump’s drops were a bigger percentage (he can consult with JD on the fancy math.) That was not long after what he calls his “record tax cut.” Trump revisited market pain late in 2018. The Democrats should have talking points on hand around Trump’s stock markets so they can counter stupid statements like “Kamala crash.” The mainstream media is especially weak on the fly on such market history as the moment passes. The Achilles Heel of Biden and Harris alike is the relatively poor grasp of economic and market facts to get right in the face of their opponent. Trump is quick to cite qualitative accolades about himself with “false facts” (aka BS) that can be easily rebutted. They need standby material, or they will continue to look lame. The 2018 market performance is target rich (see HY Pain: A 2018 Lookback to Ponder 8-3-24).
COVID volatility: The spike to 82.7 is understandable in March 2020 as the world rolled into a panic on how to operate, with deaths likely to spiral higher and smother consumer activity. That would also potentially drive mass layoffs with all the consumer asset quality and corporate sector headwinds that would come with it. Memories are short, amnesia endemic, and revisionist history is a growth industry these days.
No one knew what to do in substance early in COVID, so the default was to defensiveness, quarantines, and masks, etc. Gloves and masks were seen on thinly occupied NY subways. Over 4 years later, the policy makers and critics are born-again brave and quite certain of everything in their minds now as if they were at the time (they were anything but). The “I knew it all along” mindset of politicians is more of the usual dishonesty. (Note: At least J.D. Vance had a supply of rubber gloves in stock).
March 2022: the 36.5 VIX marks the expected end of ZIRP as inflation was rising and FOMC action imminent as the tightening cycle began. That was going to be a market adjustment as leverage would be more expensive and recession debates would start immediately.
August 2024: The close of 38.6 after an intraday 65 handle on Monday has been the focus (see Footnotes & Flashbacks: Credit Markets 8-5-24, Footnotes & Flashbacks: Asset Returns 8-4-24,Payroll July 2024: Ready, Set, Don’t Panic 8-2-24). We already see it fading today at around 25 as we go to print and the large cap benchmarks are up by over 1%. As you look at the VIX spikes above and the serious stakes that most of them show, this latest bout was more like the 2018 experience in the Trump years than the more systemic threats seen in others that often presented outsized threats to the banking system and global markets.
Even though one might seek to draw a parallel to the TMT excesses of the late 1990s that flowed into the 2001-2002 default cycle and valuation crash, that 1990s cycle was not as dominated by such outsized concentrations of valuation risk across a relative handful of mega-techs that are financially viable. The late 1990s TMT default cycle was already underway in 1999 after the underwriting cycle was an industrial-sized dog pound of cash bleeders. That default cycle turned brutal in 2000-2002. That was 3 years of pain in the credit markets and waves of litigation and regulatory revenge. That is not what we see today.