'High returns with low risk': Why wildly unpredictable economic data is a reason to buy stocks, according to one Wall Street chief strategist

The gauge last peaked at 3.5 after the financial crisis, well into its highest quartile. The coronavirus pandemic will keep the metric above 13 for at least a year, the strategist said in a note to clients.
Historically, the S&P 500's average annualized one-quarter returns reached 21.2% whenever the Economic VIX sat in its upper quartile. When the gauge stood in its middle two quartiles, the index only returned an average of 6.5%.
"An explosive Economic VIX is always unsettling," Paulsen said, but investors willing to ride out the storm of negative data are in for "an exceptional opportunity for high returns with low risk."
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An unconventional volatility gauge suggests the stock market is on the verge of massive gains, James Paulsen, chief investment strategist at The Leuthold Group, said.

Cboe's VIX index Wall Street's preferred measurement for stock market price swings has more than halved from its March highs. The stock market's rally has similarly calmed after major gains through May. Economic volatility, on the other hand, is slated to notch a post-war record, according to Paulsen.

The strategist created a metric deemed the Economic VIX for tracking such macro swings by measuring past quarters' gross domestic product growth against the historical average. The last post-war high was set in the wake of the financial crisis, when Paulsen's gauge spiked as high as 3.5, well into its highest quartile.

The metric currently sits just below the threshold for breaking into the highest quartile and readings will soon soar past their previous peak. Even by summer 2021, the Economic VIX will remain above 13, Paulsen said in a note to clients.

Economic VIX The Leuthold Group

If history is anything to go by, the unprecedented economic shakeup should serve as a boon for investors. Paulsen found that, when the Economic VIX sat above its highest quartile, the S&P 500's average annualized one-quarter gains reached 21.2%. Returns sank to 6.5% when the Economic VIX landed within its middle two quartiles, the strategist added.

The risk of investing also diminishes as volatility skyrockets. When the volatility gauge sits in its middle two quartiles, the S&P 500 registers a negative quarterly return 35.7% of the time. In quarters where the Economic VIX is in its highest quartile, that frequency drops to 22.9%.

The reasoning supporting the trend is relatively simple, Paulsen said. Forward-looking markets tend to plunge before GDP readings highlight a spike in market volatility. Once data starts to detail the extent of the economic fallout, stocks are already starting their rebound.

"Facing such conditions, investors typically raise cash and scale back exposure to risk assets," the strategist said. "Fearful investor behaviors build future buying power, conservative company behaviors bring improved profit prospects, and aggressive policies usher in a fresh economic expansion."

Even the cooling-down of the economy's rebound can bring above-average returns, Paulsen added. Weakened economic volatility indicates an economy "in the groove" and typically yields "widespread confidence among private-sector players about the economy's future," he said. Accordingly, the S&P 500 posted one-quarter gains of 16.5% when the Economic VIX fell into its lowest quartile.

The US economy will stay highly volatile through the next year, and markets will likely thrive off of the swings in GDP growth. Whether the Economic VIX keeps its heightened levels through the rebound or steadily tumbles into its lowest quartile, investors should settle in for strong gains, Paulsen said.

"An explosive Economic VIX is always unsettling, but in the post-war era, for stock investors with ample fortitude, it has provided an exceptional opportunity for high returns with low risk," he added.

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