Dogs and Earthquakes: Dueling Metaphors?

While talking about my dog as a volatility laboratory has probably been the most fun I have had writing on this blog to date, there is another volatility metaphor that should be kept top of mind as well: earthquakes.

Living in the San Francisco Bay Area, earthquakes are something I am forced to think about from time to time, whether I like it or not. A little known fact is that approximately a half dozen small earthquakes are recorded here every day. Something on the order of 99% of these are not felt by humans and are picked up only by seismographs.

On those rare occasions when I feel an earthquake, my second thought (the first one being whether I should start hedging my real estate investments with CME real estate futures) is one of relief that an earthquake has reduced some of the stress along a nearby fault. Without getting too deeply into the relevant seismology, it is generally accepted that stress builds up along faults as a result of plate tectonics, which describe the movements of the earth’s crust. Since that stress can only be relieved through the forces released by an earthquake, if earthquakes are too few and far between, the pressure on the fault builds up and scientists start worrying about an increased likelihood of The Big One.

In much the same way scientists worry about large earthquakes in the absence of smaller ones, many investors should worry about the increased likelihood of a large VIX spike in the absence of smaller ones. This same line of thinking, which I happen to agree with, would dictate that we should have been particularly concerned because the Dow had gone a record 949 straight sessions (almost four years) without a single day drop of 2% or more. More stress on the investment fault had clearly been building up below the surface, increasing the likelihood of not just a 2% drop, but also of a 3% or 4% one day drop – which is part of the reason that Tuesday’s selloff was so sharp.

Those who are paying attention may wonder if we can have it both ways: can my dog and plate tectonics both explain volatility? My dog would suggest that volatility clusters and trends. Plate tectonics suggests that volatility oscillates.

In fact, volatility clusters and trends in the short term in the same manner that large earthquakes sometimes trigger secondary earthquakes (aka “aftershocks” – akin to echo volatility) and are preceded by smaller earthquakes that are helpful in predicting large earthquakes. Over the longer term, however, my dog goes back to sleep, stress on the fault is relieved and volatility reverts to the mean – until the pressure on the fault starts to build up again and the cycle is repeated.

VIX Spikes and Echo Volatility

The action in the futures this morning might be giving us our first glimpse of echo volatility – something I talked about at length in “What My Dog Can Tell Us About Volatility.” Essentially, echo volatility is a term I use to describe the tendency for markets to be more susceptible to volatility spikes in the wake of an initial volatility spike.

Some of this phenomenon can be seen in the behavior of the VIX in the 20 days following the eight instances in which the VIX spiked at least 30% in one day. In the graph below, day 0 is the VIX close on the day of the 30% spike. In the 20 days that follow, you can see evidence of echo volatility twice looking three days out, another two times on days 9 and 10, once more on day 14, and again on day 20. In sum, six of the eight 30% spikes showed evidence of at least one additional echo spike in the next 20 trading days.

With only eight data points, I am a long way from being able to say anything about statistical significance, but if all market-related talking heads were to bite their tongue until they had something to say with a 95% confidence interval, let’s just say CNBC wouldn’t exist, nor would this blog or any of the blogs over to the right in the “Blogs I Read” section.

With that disclaimer out of the way, I decided to draw a composite picture of the 20 days following the eight instances of a 30% VIX spike. The resulting graph, below, gives values normalized at 100% of the aggregate close on the day of the 30% spike and suggests that those who are long the market should expect to contend with at least one substantial echo volatility spike in the next month and possibly one that looks and feels as dramatic as the one on February 27^th.

In the meantime, use stops and always have a plan for how to handle the next spike in your back pocket. Don't forget to pet your dog once in awhile too...

What My Dog Can Tell Us About Volatility

I am fortunate that my dog, Logan, is a well-adjusted, happy-go-lucky, 1 ½-year-old canine. To put things in perspective, his idea of a bad day in the market is any time we come home from the grocery store without cheese.

It turns out, however, that he is a walking (or running) volatility laboratory. A typical example of this is the occasional distant noise that just barely penetrates his perceptual radar, particularly on those quiet evenings when he is napping contentedly with the family. Upon hearing the noise, Logan’s altertness instantly spikes, he lets out an involuntary woof, then carefully tunes his ears to their most sensitive setting, seeking any information that will help identify the source of the noise. Usually there are no other disturbances to follow and the noise is catalogued and soon forgotten. His alertness level slowly subsides over the next 10-15 minutes or so and he goes back to napping, a little more fitfully this time and just a little bit on edge.

Things get a little more interesting when another noise surfaces shortly after the first one. What could once be dismissed as the wind, the house settling or some such insignificant event now must be treated as a threat – and just to be safe, a threat of the highest order. Now the appropriate response is a series of barks, nervous glances in the direction of the other members of the pack, brief pacing around, and a rushing off in the direction of the noise to investigate, with a flurry of barks meant to sound more menacing than the source of the noise. Who or what is it? How much harm can they cause? How grave is the threat?

It is the second noise – and any subsequent noises – that creates the equivalent of the Homeland Security red alert and triggers a response similar to what I call “echo volatility” in the markets. Once the elevated level of alertness has been established, it takes a long period of relative serenity for it to subside. On the other hand, when on red alert, any additional noises – big or small – will be magnified and regarded with the utmost caution.

In some respects, my dog is a lot like your typical investor and once he hears two or three threatening noises in a short time frame, it is a good bet that the second leg of a volatility spike is just around the corner.