Monday, April 9, 2007

When Is Echo Volatility Safely Behind Us?

Over the weekend, a reader asked an interesting question, “What day following 2/27 would you have been as comfortable as possible that the volatility index could not or would not sustain its pace?”

My knee jerk answer was that 20 trading days is the magic number for determining whether echo volatility has run its course or if the VIX is entering a period of sustained volatility. A simple test is whether the close on day 20 is below the close on the day of the VIX spike or even below the 10 day SMA.

As March 27th marked the 20th day since the 2/27 spike, the fact that the VIX had dropped 26% from the 2/27 close should certainly provide considerable comfort for those wondering whether the VIX is likely to spike back into the 20s soon.

A look at the chart I posted last Thursday confirms that following the 2/27 spike, the price action in the VIX has been the weakest yet by historical standards. In looking at that same graphic, however, the conclusions about the previous eight VIX spikes are not so obvious.

In this morning’s research project, I examined all nine VIX one day spikes of over 30% (which includes available data for the 2/27 spike) and looked at the close on the day of the spike, 5 days out, 10 days out, 15 days out and 20 days out. I then compared these to the VIX closes on days 30, 40, 50 and 60 in order to determine if any of the five day increments added meaningfully to the ability to predict VIX levels down the road. One conclusion surprised me a bit: the first ten days tell you very little about future VIX prices that you don’t already know by just applying ‘normal’ VIX mean reversion tools to the close on the day of the spike. By day 15, it is possible to predict future VIX price levels with considerably more accuracy and by day 20 I would say that I am “as comfortable as possible” about making predictions about future VIX levels and the possibility of more echo volatility. Of course, your comfort may vary...

Keep in mind that one of the golden rules of VIX mean reversion is that if mean reversion does not play out over the course of 10-20 days, then we are likely headed for a period of extended volatility. Given the events and numbers that have fallen out of the post-2/27 spike, history says that we are more likely to see the VIX back below 11 before we see it in the 20s again.


F. said...

Great article.

The volatility dropped in line with the Fed running its repo scheme soon after the 2/27 crash. Free Reserves continue to increase week-over-week which has increased liquidity (reduced volatility) in the near term. Additionally, the end-of-quarter seasonality effect added liquidity to the markets as so much proft taking occured just 1 month before, funds were bound to start accumulating again.

I agree with you that the VIX is likely to chop its way down in the short term but I do think we are in a longer term volatility uptrend. What will cause the next VIX spike? Perhaps, an unanticipated Fed rate hike earlier than anybody thought was possible...

Bill Luby said...

Good stuff, as always, F. Thanks for stopping by and adding your insight.

Just as an aside, there is a guy in Amsterdam who has been blogging exclusively on the subject of liquidity in The Global Liquidity Blog -- though he has been quiet for the last few days.

I wonder what the statistical relationship is between changes in M2 and the VIX. Maybe something for a slow day...

Bill Luby said...

Regarding liquidity and the SPX, it looks like the CXO Group has done a lot of the heavy lifting as of last December.

Their research is interesting, as is their conclusion:
In summary, M2 money supply is not a useful indicator for concurrent or intermediate-term future stock market returns.

F. said...

Thanks for the link. CXO defines M2 as "currency, checking accounts, saving accounts, small certificates of deposit and retail money market mutual funds." I don't think this data reflects short-term liquid injections such as government security repos.

As free reserves increase, banks are immediately capable of loaning this excess. Basically, the fed is lowering the gross market rate of interest even if nominal interest rates stay the same. This idea is a bit different than the one tested by CXO.

Bill Luby said...

I must confess that I have spent very little time thinking about the money supply in the past few years and only a few minutes ago discovered that the Fed is no longer reporting M3 data.

As you pointed out, M2 does not capture repos.

Some further reading, for the curious:
* Mish on Money Supply and Recessions
* The Capital Speculator on Expanding M2 Growth
* Macroblog says the disappearing M3 is a tempest in a teacup
* Barry Ritholtz thinks otherwise
* Angry Bear on the political context

[Note that there are a bunch of perma-bears who feel similarly, I happened to pick Angry Bear almost at random from the group]

This subject is beginning to look like it warrants a full post...

F. said...

Yes, sir. Examining liquidity and volatility and their relationships does provide quite an edge for swing/position plays.

The Fed has been running this repo scheme for many years. Perma bears have been predicting a collapse because of these and other Fed tactics for ages. IMHO, the Fed has a pretty good track record. They are basically just printing money and giving it to big "smart" banks who can afford a lot of research and don't usually make dumb investment decisions, while simultaneously raising the interest rates on the rest of us to avoid putting upside pressure on the CPI (inflation). It's been a successful scheme so far and I wouldn't fade the Fed.

The only problem is that these repo schemes eventually trickle down to capital goods and put an upside pressure on them which eventually works its way to consumer goods causing inflation worries. This is why I have thought (and continue to think) that the Fed will need to raise interest rates very soon.

F. said...

And of course, if the Fed does raise the rates, that will surprise many market participants. And we all know how suprises manifest themselves on Wall St: VOLATILITY.

Bill Luby said...

Interesting take(s), F. I particularly like your thinking around the Fed's two universe, two policies idea, though I wouldn't want to be the one who eventually has to bail out the 'smart' banks.

Just holler when you decide you want a weekly column here...

F. said...

The Fed is betting on the research behind these banks. Look at Goldman, some of the smartest people in the world work there. Sure they are capable of making mistakes but I wouldn't fade Goldman in the long run.

The whole purpose of a free market system is to put money (savings) into the hands of those who can put it to its most efficient use by expanding credit. The Fed recognizes that these big banks are intermediates (the means) to attain this lofty goal.

The net effect is that the Fed is using savings from around the world (foreign investors) to power innovation and production (services) in the US when they sell their securities on the open market.

Bill Luby said...

I thought I was done here, but I would be remiss if I didn't point out that by following the Ritholtz article linked above, I discovered that not only has re-created M3 from public data, but they also continue to update that information and some excellent graphs on their web site at M3 is Back

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