Over the past few weeks, we’ve been discussing how the increase in volatility can be tied to the rise in interest rates. This in turn has been deemed the most likely element that could put an end to the bull market. Today, we’re going to explore the question of volatility in some more depth, as well as its implications for options trading.

In his paper entitled Volatility and the Alchemy of Risk, Christopher Cole of Artemis Capital wrote, “Volatility fires almost always begin in the debt markets…
Volatility is the brother of credit… and volatility regime shifts are driven by the credit cycle.”

“When times are good and credit is easy, a company can rely on the extension of cheap debt to support its operations. Cheap credit makes the value of equity less volatile, hence a tightening of credit conditions (rising interest rates) will lead to higher equity volatility.” “The IMF warns that 22% of U.S. corporations are at risk of default if interest rates rise. Median net debt across S&P 500 firms is close to a historic high at over 1.5 times earnings, and interest coverage rations have fallen sharply.”

He provides this nice image of the credit cycle. Hedging and buybacks all work toward creating an illusion or alchemy of risk mitigation but in fact is an act of self-destruction ultimately turning on itself.

What’s interesting to note that is he doesn’t regard volatility as a mere reflection of changing financial or market conditions, but an input unto itself. Over time, institutions came to view volatility as an asset in itself, and trade it through VIX products.

Given that many of the volatility gauges and trading products are based on options, and in turn interest rates are one of the inputs to an option’s value, it’s easy to understand how rise in rates can create a circular increase in volatility. We saw a case of the ‘tail wagging the dog’ in early February.

Things have calmed down since then, and stocks have resumed climbing. But the connection of volatility to valuation should still be watched.  And right now, as interest rates creep higher, stocks are starting to look more expensive.

Ned Davis Research (NDR) presents the chart below, which measures the S&P 500 valuation as a function of earnings versus rates and you can see we are approaching a very overvalued level. Take a good look, and keep these patterns in mind when you’re investing.

 Related: Here’s Why The New Fed Chair Has the Market Spooked