Wednesday, October 29, 2008

Is the Fear Bubble Bursting?

There have been quite a few bubbles and mini-bubbles that have burst over the past year or so. A short list would probably include China; housing; oil; fertilizer; solar; dry bulk carriers; etc.

What about a fear bubble?

We have overshot on just about everything else, so maybe it’s time we overshot the whole business of overshooting. Fear and volatility have become so much a part of the everyday existence for those who work in the investment world that it is all too easy to take them for granted.

When I see a contract on Intrade that allows people to bet on the end of western civilization, then I’ll know things have gone too far. I haven’t seen such a contract yet, but I feel obliged to note that there is a contract for The U.S. Economy to go into a Depression in 2009, with a depression defined as “a cumulative decline in GDP of more than 10.0% over four consecutive quarters.”

Looking at previous bubbles, I wonder if the fear bubble is analogous to an oil bubble. You see macroeconomic events moving inexorably in the same direction day after day and you begin to assume the future is a predestined march down what looks like an unavoidable path.

On Monday, in Fear Is on the Decline, I talked about signs I was seeing that fear was already “starting to leave the markets.” The VIX has already fallen more than 15% from Monday’s close and there is a good chance it will be at least another decade before it sees the 80s again.

Roger Ehrenberg is out with another thoughtful piece, Is Volatility Embedded in the System for a Generation? In it, Roger paints a picture of a financial crisis receding only to the point that it exposes gaping fundamental holes in the economy, the substantial risk of a Japan-style deflation, and a Fed so determined to prevent deflation that their easy money policy leads to runaway inflation and ultimately some sort of cruel game of low growth inflation-deflation ping pong.

In such an environment, which I would not consider to be too far-fetched, Roger describes a VIX of 40 as the new 20 and predicts a much higher floor for volatility in the future.

On the other hand, I am reminded of a post I titled The Big Question for the VIX back on May 22nd when the VIX closed at 18.05. The big question back then, with a financial crisis raging, oil approaching 150, and investor anxiety on the increase, was why the VIX was below 20.

Just five months ago, which was the more unlikely scenario: crude oil at 60 or the VIX at 90? It’s hard to say, but suffice it to say that it would have been hard to find the appropriate strikes to even make such a bet back then.

In the last five months, cause and effect has flipped. Not too long ago it was oil prices that were driving estimates of future economic activity and volatility, now the economy is the cause and oil, volatility and the like are the effects.

One day of 900 points gains in the Dow Jones Industrial Average will not fix all the economic woes on the horizon. It just might, however, signal an end to the runaway bull market in fear.

10 comments:

Mikkel said...

I'm not going to stick out my neck and say we won't see a VIX above 80 in the near future, but there are only a couple of weeks left for that to happen IMO.

I base this by looking at historical volatility during the great depression. Volatility is a function of uncertainty, and I think that even if we do have the worst case scenario (well besides complete collapse) that we are close to the point where that expectation is ingrained into the system.

Our historical volatility seems to be about where it was during the '29 panic, and even though the market obviously went on to lose much much more, it was in more rhythmic patterning.

It'd be interesting if they had IV statistics then but I doubt that they would have gone up to 90 after the initial crash. I think that as a generation we're conditioned to believe that prosperity and fear are opposites, but during sustained collapses despondency can be the reason for reduced fear as well.

Hopefully that won't happen, but is just an argument why the fear "bubble" might be near a peak.

Mikkel said...

Oh as an addendum, the reason why I don't think we're out of the woods yet is the GDP number. I read that as much as 80% of the "growth" in Q2 was from increased import prices.

We'll still see some impact from the stimulus checks, but import prices crashing will count negatively against the GDP. I have absolutely no idea what will show up (especially since spot prices aren't good predictors of contract prices and I don't keep up with those) but wouldn't be surprised if it was -1.0 to -1.5% or even greater.

We could see a very awful top line number that isn't as much of a reflection of how quickly things are falling apart as much as numerical quirks and that could easily bring us to new reaction lows. We get through tomorrow/Friday's data and I don't see how we get VIX back up to new highs.

Bill Luby said...

Mikkel,

I think you are correct about imports and GDP, but I think a recession -- even a severe one -- is much less daunting than a global financial meltdown.

Regarding historical volatility, I used DJIA data going back to the 1920s and exactly to your point, 30 day HV hovered around 90 for about 18 trading days in Oct/Nov '29, popped up to the 70s for awhile in late '31, but never even made it above 50 in in '37.

DJIA 30d HV just went over 70 yesterday; it was just under 80 in the SPX yesterday.

I agree that there is a window for accelerating fear that window seems to be closing.

Now let's see how we react to the Fed...

Good comments!

-Bill

Mikkel said...

Bill at this point it's *all* about exporting economies and more to the point currencies. A GDP number that points to a contraction greater than anticipated may have the effect of the yen/$ increasing at the clip they were last week and this would bring a global financial meltdown back into play due to feedback loops.

When advanced economies such as Australia are seeing their currency devalued by 3-5% a day things get out of hand quickly. The primary reason we had the bounce IMO was because the $ and yen stopped their rapid ascent, but it's hard to know if that was due to massive government intervention that was a one time shot.

Adam said...

today is the 18th consecutive day of VIX above 50... looks like there is still plenty of fear in the market.

Noble said...

I cant see things settling until insolvency issues have been taken care of. Why would GS be talking to C(!) about a merger?

Just a "fear bubble" getting to those really smart guys at GS?

Yuk, yuk, yuk!

Anonymous said...

It is interesting that the December S&P 500 futures traded at 966.5 at 3:50 PM EST and that they traded at 928.0 at 4:00 PM EST. This represents a 28.5 S&P 500 point movement and a 2.95% movement in a ten minute period of time. The DJIA futures traded at its daily high of 9345 after 3:45 PM EST and it traded at a low of 8870 before 4:00 PM EST. This represents a 475 DJIA point range in less than fifteen minutes of trading. These were the largest fifteen minute movements in these futures contracts for any period of time during the day, including the trading that occurred after the FOMC interest rate announcement.

Anonymous said...

when all you have is a hammer everything looks like a nail.
Not everything is a bubble, think about it and you may just see more than nails

Allan said...

Not even close; fear evaporates with every rally spike as the bottom pickers are in a buying panic to not miss the bottom. When stocks become shunned by every pundit and investor, then we know that fear has run its course and its time for a tradable rally. Until then, every rally is a short.

eh said...

I don't think anyone is trading on real conviction at the moment, especially longs. More out of fear and a desire to speculate. Given that anything can happen, as you've seen.

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