We are witnessing volatile times like no other —in stock markets, energy markets, geopolitics and supply chains—as the pandemic slowly leaves behind an undefinable economic wake. These factors become embedded in the valuations and earnings expectations of firms. Novel research by Accounting Professor Sean Wang of SMU Cox with his coauthors offers a new measure to identify those firms that are bellwethers, the firms that move markets and track the volatility reflected in the market. It’s like financial market rocket science.
Bellwethers are microcosms of the macroeconomy itself. Prior research has addressed and analyzed bellwethers, like the Dow Jones Industrial Average or DOW 30, for example, using firm size as a measure. The Dow, is a stock market index of 30 prominent companies listed on the U.S stock exchanges, one of the oldest and most commonly followed equity indexes. Wang says this is somewhat mechanical, having never been well-documented per se or grounded in theory. The share prices of the five biggest tech firms included in the S&P 500, comprising up to a fifth of its market capitalization, have fallen by 40% this year, notes The Economist recently.
“Our research focuses on volatilities because they are information shocks to the market,” says Wang. Past work has focused on volatility from actual stock returns, ie., realized volatilities. “Our research focuses on implied volatilities, which are forward looking based on options traders’ beliefs about future incoming information,” he notes. These traders are believed to have better information than general equity market traders. Wang’s metric looks at individual firm-level volatility relative to market volatility, how they move together. The outlook of these options traders captures what the sophisticated investors believe.
Metric of the future
The author’s metric called “implied volatility co-movement” or IVC measures incoming information from firms (earnings and growth expectations) and incoming expectations of the market. The firms whose news moves with, and moves the market, are essentially the bellwethers. “We show that firms with high IVC tend to move the market more than firms with low IVC,” Wang explains. In the case of Disney, a firm with high IVC, their announcement to replace their CEO, and the subsequent large market moves, were likely more related to the dynamics set up in the post-pandemic world.
Wang and his coauthors devised the ultimate test to determine whether their theories about high IVC firms acting as the pulse of the market were true. They examine whether insider trades at these high IVC firms were predictive of aggregate equity market returns. This test is powerful because research has shown that insider trades are advantaged because insiders understand the ins and outs of their own firm better than others, but do not possess information advantages about the economy in general. However, if it were the case that these firms were microcosms of the market, insider trading on their own firm’s future would be anticipating future aggregate market movements. Their results say that insider trades at high IVC firms are more strongly associated with future aggregate returns. Thus the authors’ theories that these firms reveal information as bellwethers to upcoming market movements was validated.
In addition to the IVC measure being well-grounded in asset pricing theory, Wang also notes that their model’s measure is more dynamic than other measures based on size or market capitalization. “Our bellwether method is more dynamic,” Wang offers. “[Attributes] like size tend to be rather sticky over time, or like the Dow Jones 30, being sort of arbitrary.” There’s no official way that these firms are actually chosen. “Our metric actually has a methodology and a theory behind it,” he adds. “One potential advantage of using IVC is that it moves with the pulse of the market.”
Pandemic times and beyond
In considering how his model ran regarding new bellwethers during the pandemic, he cites both cloud-based tech firms and biotech as money managers and investors tried to identify those firms that would lead and impact the market. Now he points to consumer discretionary stocks like Home Depot and Walmart leading in this inflation-driven environment, coupled with the ascent of energy.
Regarding the recent turmoil in markets, Wang says that he’s been looking at market volatility in general and suggests that the market is still trying to find equilibrium. Capital budgeting allocations are changing as it relates to monetary policy changes to the Federal Funds rate that resulted in a low of 0.25% during the height of the pandemic, slowly rising upwards since January of 2022 to 4.00% as of December 2022. Following valuation theory based on discounted cash flow analysis, market values largely based on expected long-term growth, such as most intangible investments, become massively discounted when interest rates are revised upwards. In today’s world, nowhere is this more apparent than in tech stocks such as Meta, Amazon and Google, with serious jobs (human capital) being slashed as firms undergo widescale restructuring in response to the new economic environment.
Relative to the state of the market, Wang says, “A lot of human capital is being shed across the board, we’re going to look back and see this time for the bubble that it is,” in reference to how tech stock valuations rose to new all-time highs during the pandemic. Low interest rates played a role. Wang also notes that, while the significant valuation cuts at big tech offer an immediate cost reduction, these strategic layoffs effectively abandon human capital investments which would ultimately add future value to the firm. Interestingly, Wang notes that these laid-off workers still possess such knowledge; they will ultimately be rehired and that human capital will ultimately be recycled into the economy at a later date.
In the future, Wang and coauthors may delve into industry and sector analysis relative to their IVC measure. They would then consider what bellwethers emerge within an industry such as energy or tech. “This study area might be extended or applied to reveal how competitive advantages among firms change over time, as we have always seen with the GEs of the world or U.S. Steel,” says Wang.
New market dynamics are creating the need for new advances that mirror them. IVC may just be an answer—it’s a leap into the new frontier.
The paper “Information from Implied Volatility Comovements and Insider Trades” by Sean Wang, Cox School of Business at Southern Methodist University, Robert Bushman, University of North Carolina, and Vivek Raval, University of Illinois at Chicago is under review.
Written by Jennifer Warren.