The Case Against High Stock-Market Volatility in 2016 (Guest Columnist at Barron’s)

About a month ago, when Steve Sears and Barron’s asked if I would be interested in writing the first The Striking Price of 2016 and share my perspective on what to expect in terms of volatility for 2016, I jumped at the chance.  I quickly made a list of more than two dozen reasons why I felt volatility is likely to rise in 2016 relative to 2015 levels and began to outline the case for why investors should be cautious about the financial markets in 2016.

Since then, every pundit has unveiled their 2016 crystal ball and almost without exception, the consensus is for a significant rise in volatility in the coming year.  While I certainly understand the rationale behind these calls for an increase in volatility in 2016, I can add little value to the dialogue by rubber-stamping the consensus opinion.  In fact, I am probably better off just pointing you to last week’s The Striking Price column, where former colleague Jared Woodard channels some of the more compelling of my two dozen plus higher volatility ideas in Prepare for Rising Volatility in 2016.

So, given that I hate overcrowded consensus trades, strongly believe that volatility is extremely hard to predict and am intimately familiar with data that shows market participants have a habit of overestimating future volatility in stocks, I decided that today’s Barron’s column should be The Case Against High Stock-Market Volatility in 2016.

Today’s column draws on a good deal of research and analysis I have present here in the past and also touches upon themes from some previous Barron’s columns.

Of course, one should take all of this volatility prediction stuff with a grain of salt, as back in May 2010 in Barron’s I was critical of the art and science of predicting volatility in The Perils of Predicting Volatility.

Related posts:

• VIX Term Structure and VIX Forecasts
• Was the VIX Too Low in 2013? No…
• Violent Disagreement Across VIX Futures
• The Gap Between the VIX and Realized Volatility
• Extremes in the Spread Between the VIX and 20 Day Historical Volatility in the SPX
• VIX Futures: What Were/Are They Thinking?
• Average Annual Normalized VIX Futures Term Structure, 2004-2014
• Revisiting the VIX:VXV Ratio
• The VIX, Lehman Brothers, and Forecasting
• Volatility Aces Bloggers
• What Is Historical Volatility?

A full list of my (17) Barron’s contributions:

• The Case Against High Stock-Market Volatility in 2016 (January 2, 2016)
• Seizing Opportunity From Stock Market Volatility (July 11, 2015)
• How to Ride an Aging Bull (November 29, 2014)
• Investors' Best Options in a ‘No Fear’ Market (July 2, 2014)
• Low Volatility:  How to Profit from a Quiet VIX (May 22, 2014)
• Emerging Market Stocks:  Have They Hit Bottom? (March 28, 2014)
• How to Spot Risk Early (July 16, 2013)
• How to Insure Your Stock Portfolio (April 18, 2013)
• The Case for Options Trading (January 2, 2013)
• Calm Down and Exploit Others’ Anxieties (November 14, 2012)
• How to Trade Options Around Volatile Events (July 10, 2012)
• Be Greedy While Others Are Fearful (May 3, 2012)
• Ways to Turn Volatility into an Asset Class (January 12, 2011)
• There’s Opportunity in Uncertainty (November 18, 2010)
• Will Market Volatility Return to Crisis Levels? (September 15, 2010)
• The Perils of Predicting Volatility (May 20, 2010)
• Take a Longer View on Volatility (July 2, 2009)

Disclosure(s): none

Today’s Jump in the VIX Futures Term Structure

When we see a large VIX spike, I invariably see a similar spike in emails with the theme of “Are we there yet?” Naturally, investors want to know how far the VIX is likely to move, when the markets should be expected to reverse and whether they should trade with the rising VIX or against it.

These are all great questions and for the most part, the answers are not as simple as just plugging the current data into a spreadsheet and having it spit out something like another 2.16 points, 1.5 days and ‘start fading the VIX 45 minutes after tomorrow’s open…’

What is possible is to look at prior VIX spikes and understand some statistical tendencies. The more difficult part is to put VIX spikes in an overall context and answer questions such as whether the market had been trending up or trending down, whether the proximate cause of the selloff in stocks is geopolitical, macroeconomic, technical or whatever. (See Forces Acting on the VIX for a laundry list of potential influences on volatility.) Combining the art of context with the science of statistics, we are now on the doorstep of the dark art of forecasting volatility.

The best place to start when evaluating the current state of volatility is with the market’s expectations of future volatility and the best place to gather this information is in the form of VIX futures (or perhaps SPX implied volatility). The graphic below shows how market expectations of future VIX values have changed from yesterday’s close (dashed blue line) to about 1 hour and 40 minutes into today’s session (solid red line.) While it certainly has felt like a huge move, with the VIX up 17%, the 10.1% move in the front month (August) VIX futures still leaves us well below where investors believe the VIX will be in September and October.

The other important point to note, particularly if you are relatively new to VIX futures and want to understand them in the context of how they influence the VIX ETNs (VXX, XXV and VXZ), is that the VIX futures moves are not proportional. In fact, the front month typically moves much farther in percentage terms than the second month does, the second month moves more than the third month, and so on. One look at VIX Futures: The One Picture to Remember should drive that point home rather forcefully. The reason why front month futures are more sensitive to changes in the VIX than back month futures has to do with mean reversion. Simply stated, any one day movement in the VIX should do very little to change one’s view of where the VIX will be six or seven months out. On the other hand, with VIX August futures and options set to expire one week from today, the ripple effect from today’s action is certain to be felt in terms of how investors are looking at stocks – and volatility – one week from now. This also gets at the essence of the difference between VXX and VXZ as well as the slope of the term structure (whether it be in contango or backwardation) in the front months versus the back months.

For more on related subjects, readers are encouraged to check out:

• Weekly Options Gain Momentum
• Forces Acting on the VIX
• A Conceptual Framework for Volatility Events
• Availability Bias and Disaster Imprinting
• More Volatility + Less Fear = Lower VIX?
• VIX Term Structure Changes Since November 20th
• VIX Futures: The One Picture You Need to Remember

[source: FutureSource.com]

Disclosure(s): short VIX and VXX at time of writing

Guest Columnist for Steven Sears at Barron’s

Steven Sears at Barron’s has once again been kind enough to give me an opportunity to author a guest column for The Striking Price while he is on assignment.

With the VIX in the 40’s this week, I elected to write about how difficult it is to forecast volatility. In The Perils of Predicting Volatility, I talk about how the VIX typically underestimates large volatility spikes and overestimates the extent to which volatility will remain high following a VIX spike.

The Barron’s article integrates many of the ideas I have been blogging about for the past few years, some of which are included in the links below.

For those who may be interested, the last time I contributed to Barron’s was with Take a Longer View on Volatility – a subject that I think is quite timely today, given the recent volatility surge.

For more on related subjects, readers are encouraged to check out:

• VIX Term Structure and VIX Forecasts
• Availability Bias and Disaster Imprinting
• How to Trade the VIX
  
• Short-Term and Long-Term Implications of the 30% VIX Spike
• A Conceptual Framework for Volatility Events
• Forces Acting on the VIX

Disclosure(s): short VIX at time of writing

Opinions Wanted: Predict the VIX on 12/31/2010

Let's see how well the wisdom of the crowds works.

Instead of a simple poll, I am curious not just where readers think the VIX will be at the end 2010, but also what some of the more important forces acting on volatility will be in the coming year.

So go ahead and make those comments sing...

Disclosure: none

VIX Term Structure and VIX Forecasts

Last Friday, Jeff Kearns of Bloomberg had a story with the title VIX Futures Show Traders Betting Stock Rally to End that triggered a large number of emails from readers. The quote from the article that seemed to generate the most amount of interest was, “Investors surveyed by Macro Risk Advisors expect the VIX to jump to as much as 51.70 by year end.” In fact, the 51.70 data point was the average high print expected by respondents who were surveyed in April, when the VIX ranged from 33 to 46. That data point and the balance of the results from the Volatility Forecast Survey make for some interesting reading. Even more interesting, however, is the April 2008 Volatility Forecast Survey, in which respondents expected average realized volatility of 20.9% for the balance of 2008, with an average VIX high print of 34.4. One brave soul went out on a limb and predicted that the VIX would spike to a new all-time high of 50.

I guess nobody knew what a category 5 VIX hurricane looked like, so extrapolating from historical data, they were having trouble imagining what was coming.

Getting back to the 2009 survey data, while I find it intriguing, I would put a lot less credence into survey data that is several weeks old than real-time market data. One can construct a VIX term structure graph from VIX futures or SPX options. My preference is for the latter approach, which yields a graph like the one below. Note that the slope of the VIX term structure is almost flat. Certainly the 0.11 differential between the front month and 2 ½ years out is in stark contrast to the 33.93 point differential from November 20, 2008, when the front month VIX was 81.07. Essentially, the consensus opinion is that current volatility measures are about where they should be, with no significant changes anticipated going forward.

Finally, while survey respondents likely had the best of intentions when constructing their volatility forecasts last month, there is nothing like current market data to get a sense of how investors are backing up their beliefs with large dollar value positions in the options market.

[source: CBOE, VIXandMore]

How Low Can the VIX Go?

With the bank stress tests results and the April employment report out of the way, volatility is cratering and the VIX is down to 31.45 as I type this.

So how low will the VIX go?

A little more than two weeks ago, in The New VIX Macro Cycle Picture, I suggested that for the current bull leg, 30 was a good guess for a VIX floor. That prediction was part art and part science, to be sure, but there were quite a few technical factors that went into the calculation.

You don’t need a fancy model, however, to make a ballpark prediction for the VIX. I will share a quick and dirty back of the envelope calculation. Since the VIX averages approximately 1.3x the historical volatility of the SPX, one can use the 10, 20 and 100 day historical volatility data to come up with three estimates of the VIX. Generally, I take the lowest one as a floor and average the two readings that are closest together to come up with an expectation of an appropriate current level of the VIX.

With the 10 day historical volatility at 24.10 yesterday, a 1.3x multiplier yields a 31.33 VIX. For the 20 day HV, the numbers are 29.95 and 38.93. The 100 day HV, which includes SPX data going back to December 12^th, is 37.52, with a 1.3x multiplier yielding 48.77.

So…the back of the envelope calculations suggest a VIX floor of 31.33 (today’s low is 31.39) and an appropriate current VIX of 35.13.

Remember that these are guidelines at best and assume that the next 30 days will bear a reasonable resemblance to recent history. Still, they support the contention that we are nearing a VIX floor.

For the record, the lowest 10, 20 or 100 day historical volatility level recorded in the past six months was a 10 day HV of 20.38, which translates into a VIX of 26.69. For anyone looking for the lowest possible extreme in the VIX in the near future, 26 would be a good bet. This is also consistent with my earlier prediction that the VIX is not likely to breach a floor of 25-27.

Condor Options Looks at Volatility Forecasting

Volatility forecasting is a subject that I spend a lot of time with behind the scenes, yet rarely post about on the blog. Part of the reason for my reticence to post on the subject is that my own efforts to develop a volatility forecasting model have demonstrated that whatever proficiency I am developing seems to be limited to at most a 2-3 week forecasting period.

That being said, whenever I see Condor Options write about a subject that I have an interest in (which is almost every time something appears on their site), I take notice. Today my avian friends are tackling Forecasting S&P 500 Volatility, using a variety of approaches, including SPX implied volatility, VIX futures and a trio of GARCH(1,1) forecasting models. The consensus? None, really. The SPX IV data anticipates the most volatile future, while the GARCH(1,1) models see volatility dropping off more rapidly. Check out the full article for the details.

My forecast? Partly cloudy, with a chance of gradually diminishing volatility over the course of the next 2-3 weeks.

The VIX, Lehman Brothers, and Forecasting

Jeff Kearns and Michael Tsang of Bloomberg have an article out today (VIX Fails to Forecast S&P 500 Drop, Loses Followers) in which the authors contend that largely because the VIX failed to predict the October losses in the S&P 500 index (SPX), the VIX is no longer considered to be an accurate gauge of future market activity.

One of the central claims made by Kearns and Tsang regarding the lack of effectiveness of the VIX is stated as follows:

“On Sept. 11, less than a week before New York-based Lehman Brothers Holdings Inc. went bankrupt and four days after the government takeovers of Washington-based Fannie Mae and McLean, Virginia-based Freddie Mac, the VIX closed at 24.39. That meant traders bet the S&P 500 wouldn’t fluctuate more than 24.39 percent on an annualized basis, or about 7 percent in the next 30 days, and implied a range for the index of 1,161.11 to 1,336.99.

One month later, on Oct. 10, the S&P 500 closed at 899.22, or a record 23 percent lower than what the VIX predicted.”

As fellow blogger Don Fishback was quick to point out, the VIX calculation actually estimates one standard deviation of annualized 30 day volatility expectations in SPX options. That standard deviation, of course, is meant to capture 68.3% of the Gaussian or normal distribution of prices. In fact, the distribution of VIX prices does not follow a normal distribution, but even if it did, the movements from September 11^th to October 10^th would not be that statistically improbable.

Some quick comments on the math involved here. Using a VIX of 24.39, the conversion of an annualized volatility of 24.39% to 30 day volatility yields a 30 day volatility of 7.04%. Two standard deviations translate into a 30 day volatility of +/- 14.08% and should cover about 95.5% of the normal distribution (I am assuming a normal distribution for the sake of mathematical simplicity). Three standard deviations increase the range of expected volatility to +/- 21.12% and should capture about 99.7% of the normal distribution. In fact, the 99.9% boundary for the normal distribution is 3.29 standard deviations and translates into expectations of an SPX move of 23.16%, about on par with what transpired. So, given that an event which falls outside of 99.9% probability distribution happens once every 1000 instances. Rare indeed, but not unfathomable.

Of course there are many ways in which to utilize the VIX to aid in market timing. Consider that the nature of the VIX calculation is such that the VIX acts as an unbounded oscillator whose values are derived from prices paid for options on the SPX. Like most oscillators, traders tend to use extreme values as opportunities to bet on a reversion to the mean.

A good deal of the difficulty in understanding the movements of the VIX is that some of the dominant patterns are different over the course of different time horizons. For instance, in the short-term, the VIX commonly spikes and mean reverts. Looking at the intermediate term, the VIX frequently establishes strong trends; and in the long term, the VIX has a tendency to move in cycles of 2-4 years. For the month of September and most of the month of October, the VIX was in an uncharacteristically strong sustained uptrend.

Part of the reason for the sharp move in the VIX during September and October is that it is highly dependent upon macroeconomic and fundamental events that help to shape investor perceptions of uncertainty, risk and fear. In the week leading up to the Lehman Brothers bankruptcy, for instance, very few investors believed that the government was prepared to let Lehman fail. Additionally, in retrospect is seems as if those who did believe failure was an option did not comprehend the nature of the systemic reverberations that a Lehman bankruptcy would trigger.

The bottom line is that during the second week in September, the VIX was pricing in a very low probability of a Lehman Brothers bankruptcy. Perhaps more important, investors were also assigning a significantly lower systemic threat potential as a result of the dominoes associated with a Lehman bankruptcy.

Ultimately, it took a full six weeks of a steadily trending VIX for the market to fully price in the global systemic risks associated with the sequence of events that began with the Lehman Brothers bankruptcy.

Consider that the prices and implied volatilities of SPX options have to account not just for the probabilities associated with various future scenarios, but also the magnitude of the impact of those scenarios on the stock market. For this reason, even while some of the probabilities may not have varied significantly from day to day during September and October, as the magnitude of the financial crisis was slowly revealed, the VIX continued to ratchet higher – and investors reacted to a rising VIX with increasing alarm.

Getting back to the question posed by Kearns and Tsang, yes the VIX underestimated future volatility back on September 11^th. At that time, the prediction of a four year flood was consistent with mainstream thinking. Very few observers anticipated the SPX falling below 800 by Thanksgiving.

As the year winds down, I will have more about what we learned about volatility in 2008 and what some of the implications are for 2009 and beyond.

Recent Volatility and VIX Macro Cycles

The science art of forecasting volatility more than a couple of weeks out has always struck me as a lot more like astrology than astronomy, so it was with some mild apprehension that I thought I should update my VIX macro cycle chart here and see what previous posts in this area predicted for 2008.

The good news is that in December 2007 in Was 2007 the Beginning of a New Era in Volatility?, I managed at least to nail the persistence of the recent trend by noting, “the current rise in volatility should persist through all of 2008, even if the rate of rise in volatility begins to slow.” In what looked like a much safer prediction, I said, “the rate of change in volatility over the course of 2007 is unsustainable going forward – or at least inconsistent with the slope of volatility macro cycles during previous cycles.” As the monthly chart below shows, the VIX essentially moved sideways to down from July 2007 through August 2008, at which point the recent volatility began in earnest.

My most recent VIX macro cycle update comes from March 19, 2008, just three days after Bear Stearns was sold to JP Morgan (JPM). At that point in time many believed volatility seemed to understate the gravity of the financial turmoil. For historical context, I will repeat my assessment at the time:

I still anticipate that volatility will spend a good portion of 2008 in the neighborhood of 22-26. Looking at the current VIX futures quotes, where the May through December futures are all trading just below 26, it looks as if my prediction is on the low end of the market consensus.

The big question I have is about the duration of current VIX macro cycle – and of course the slope of any continued increase in volatility. If the current slope of the volatility increase holds and the minimum cycle time is two years, that would project to a sustained VIX of about 40 by the end of the year. I don’t expect to see that scenario unfold, but it will be interesting to see how long it takes for the runup in volatility that started about 15 months ago to run out of steam.

So…7 ½ months later I can say that my prediction held up through mid-September, but once Lehman Brothers filed for bankruptcy, the LEHVIX and VIX went through the roof and my predictions went out the window.

From a macro cycle perspective the two questions to ask now are how long the current cycle of increasing volatility should last and what direction the next cycle will take. Using the historical norms of a 2-4 year cycle and considering the steep trajectory of the recent 22 months of increasing volatility, I suspect that the current cycle is nearing an end and either topped out at the beginning of the week or will see one final topping move in the next month or two.

The direction of the next move is the bigger question and the more difficult one to answer. Two of the three previous changes in volatility have ended in a multi-year sideways move. Given some of the structural and fundamental challenges currently facing the economy, the easier prediction to make seems to be several years of elevated volatility.

I am going to go out on a limb, however, and stick to my fear bubble thesis to predict that volatility will be on the wane over the course of the next two years or so. Don’t succumb to anchoring when it comes to a VIX of 70. Just two months ago the VIX was in the teens. While it may be awhile before the VIX returns to the teens, I would not be surprised if the VIX were back in the 20s in another 2-3 months.

Of course, a large part of the path forward will be strongly influenced by the policies and regulations put into place by governments that have yet to take office – all of which substantially increase uncertainty around any prediction.

[source: StockCharts, VIX and More]

VIX Macro Cycle Update

In the year plus that I have been blogging about the VIX, I have periodically discussed the idea of VIX macro cycles. These cycles tend to last about 2-4 years in which the VIX has a definite trending pattern, but occasionally include a cycle of similar length (e.g., mid-1998 to late 2002) in which the action in the VIX is generally sideways.

I last spoke about VIX Macro Cycles at length in December, at which time I posed the question, Was 2007 the Beginning of a New Era in Volatility? Given the extreme slope of the VIX increase over the course of 2007, I concluded that a new VIX macro cycle was indeed under way, but hedged my answer a bit at the time when I said “the current rise in volatility should persist through all of 2008, even if the rate of rise in volatility begins to slow.”

At the time I made that statement, I certainly did not anticipate that we would see multiple VIX spikes in the 30s during the first 2 ½ months of the new year, but even those events and the broad concerns about the stability of the financial system have not caused me to back away from my December prediction that volatility would flatten out “in the low to mid-20s range.” In fact, I still anticipate that volatility will spend a good portion of 2008 in the neighborhood of 22-26. Looking at the current VIX futures quotes, where the May through December futures are all trading just below 26, it looks as if my prediction is on the low end of the market consensus.

The big question I have is about the duration of current VIX macro cycle – and of course the slope of any continued increase in volatility. If the current slope of the volatility increase holds and the minimum cycle time is two years, that would project to a sustained VIX of about 40 by the end of the year. I don’t expect to see that scenario unfold, but it will be interesting to see how long it takes for the runup in volatility that started about 15 months ago to run out of steam.

McMillan on Interest Rate Moves Preceding Volatility

Interesting fodder for further contemplation, from options guru Larry McMillan in Barron's: Volatility Likely to Remain High in 2008.

The article is much more interesting that the title might suggest and discusses a 'theory' that short-term interest rates precede volatility by 2 1/2 years. While this sounds like a stretch to me, if you believe the theory, then the VIX should be topping in early 2009 -- which just happens to be about the time suggested by some of my VIX macro cycle work. Certainly worth a click through for the curious...

Was 2007 the Beginning of a New Era in Volatility?

From the chart below, it certainly looks as if 2007 was the beginning of a new volatility macro cycle. It also looks as if the rate of change in volatility over the course of 2007 is unsustainable going forward – or at least inconsistent with the slope of volatility macro cycles during previous cycles. I am not going to make a specific long-term volatility forecast for 2008, but it would not surprise me if volatility flattened out in the low to mid-20s range in much the same manner that it did from late 1998 to early 2002.

While VIX macro cycles are somewhat dependent upon a subjective determination about the beginning and ending dates for each cycle, it should be noted that these cycles tend to last a minimum of two years, suggesting that the current rise in volatility should persist through all of 2008, even if the rate of rise in volatility begins to slow.

The evolution of the current macro cycle will undoubtedly be a big story to watch in 2008; VIX and More has a front row seat to watch the action and provide the play-by-play and color commentary as appropriate.

Volatility in a 130/30 Era

Kudos to Adam at Daily Options Report for highlighting a Barron’s article by Dennis Davitt of Credit Suisse in which Davitt makes some interesting predictions about volatility going forward.

Speaking about one of my favorite subjects, VIX macro cycles, Davitt predicts that the key factor in the next few years will be the influx of money from 130/30 funds that will create significant new demand for options products:

“In the past, when the market made new highs, the VIX trended lower. Today, the S&P 500 is up 6.5% on the year and the VIX is up 80%, and the newest user hasn't even shown up to the party yet. That user is the 130/30 money (a type of leveraged long-short investment strategy), which now stands at $100 billion and is projected to grow to $1.5 to $2 trillion over the next three years. With these new entrants using derivatives to hedge their portfolios, option-buying is sure to take a jump.”

Adam’s commentary on the subject closely approximates my own thinking (I’m glad he gets up three hours earlier to figure all this options and volatility stuff for me…):

“I think an underlying theme of all this is that different eras have different characteristics, and it's important to look at volatility within it's own context. In other words, a 15 VIX was actually fat a couple years ago, the market itself had trouble trading at double digit volatility. Today 15 might be as low as it gets.”

Not only do I agree with Adam here, but I think it is important to note that if the projections about new 130/30 money are on target, this could be one of the biggest stories of the next few years.

VIX Macro Cycles

On my very first post in this blog, I offered a monthly chart of the VIX from 1993 to January 2007 and identified what I called four VIX macro-periods as follows:

1. relatively low, flat volatility for 3 years from 1/93 to 1/96
2. increasing volatility for 1 ¾ years from 1/96 to 9/97
3. a five year period of extreme volatility from 9/97 to 9/02
4. the current period of decreasing volatility that began in 4/02 and continues to the present

Now that I have more familiarity with StockCharts, I have updated that chart to reflect the full range of monthly VIX candlesticks from the first official CBOE data in January 1990 to the present. Adding one macro-period to the beginning and end of the original VIX chart, I now have six VIX macro cycles. Ironically, the current period starts just about the same time I started this blog.

A couple of comments on the VIX macro cycle graphic below:

• This model is a work in progress, even though I like the way it reads at present
• 2-4 year cycles appear to be the norm (I had earlier favored 3-5 year cycles)
• The slope of the current macro cycle is unprecedented for the time periods considered
• The gap between the current monthly candle and the moving averages is also unprecedented

Going forward, I will have a lot more to say about my VIX macro cycle idea, long-term VIX moving averages, and long-term VIX forecasts.

[One quick note on the ‘methodology’ used above. As this chart is more art than science, you could certainly make an argument, as I did the last time around, that the transition from C to D happened in October 1997 instead of October 1998. Frankly, I think either interpretation is correct and does not materially affect any long-term view of the macro cycles.]

Can the VIX See a Year Out?

Even before Adam Warner and I were humbled in our attempt to forecast the VIX one month out, I have been slow to warm up to the predictive value of the VIX looking out more than a month or two – all of which makes Eric Boughton’s “The Predictive Value of the VIX: Room for Divergent Opinions” particularly interesting reading.

First, the bad news: Boughton concludes that “knowing what the VIX is today is not likely to give you any aggregate useful information about whether returns will be high or low over the next year.” The good news is that the VIX does a reasonably good job of predicting future volatility over the course of the next 12 months.

While Boughton’s target time frame of one year may not be the best way to test the predictive value of the VIX, the tidbit I found most interesting was tucked away at the bottom of Boughton’s article, in which he notes that “buying the S&P on every day the VIX exceeded 30, and holding it for a year, resulted in an average return of 17.15% (as compared to the average return of 10.28% available for all twelve-month periods during the period in question).” His conclusion? Even if there is no correlation between the VIX and one year returns, “the market seems to pay an outsized return in exchange for the risk of buying when fear is high.”

My thinking continues to be that middling values in the VIX are generally not worth talking about. In the end, it is VIX spikes and mean reversion that matter most – and those factors are easiest to predict over the course of about 5-10 trading days.

The SPX:VIX Ratio, the Mean Reversion Magnet, and Fun With Numbers

During all the excitement of the past week, quite a few indicators printed extreme readings. One that was all over the press was the surge in new lows. Babak, Dr. Brett and Headline Charts did such an excellent job of covering this one that it hardly seems worth noting again here.

Another indicator to print extreme readings that I’m sure I follow much more closely than others is the ratio of the SPX to the VIX. I’ve written a fair amount about the SPX:VIX ratio in the past and am of the opinion that the 10% trend line (for an explanation of the 10% trend line, try “The SPX:VIX Relationship”) acts as an intermediate to long-term mean reversion magnet.

One interesting aspect of the ratio is that it does not specify which of the variables will mostly likely be responsible for moving the ratio back toward the historical trend line. Given that the VIX is much more volatile than the SPX, it is natural to assume that the VIX will make the sharper move, so with an SPX of approximately 1500 and a SPX:VIX ratio of 115 or so, this implies a VIX of 13.04. One interpretation of this calculation is that the VIX is approximately 50% ‘too high’ for the current level of the SPX. Of course, another possible interpretation is that the VIX has been ‘too low’ for much of the baseline period.

Another way of looking at the ratio is to fix both the ratio and the VIX and solve for the SPX. Assuming a VIX in the neighborhood of the current 20 value and a SPX:VIX ratio of 115, this projects to an SPX of 2300, which stretches the limits of credibility a little too far for my taste.

So…if you believe in a relatively constant long-term relationship between the VIX and a trending SPX and all the assumptions that go along with it, which of the two scenarios is more likely to bring the SPX and VIX back toward an equilibrium: an SPX of 2300 or a VIX of 13?

For the record, I do believe in the trend line magnet properties of the SPX:VIX ratio, but I am quick to note that the mean reversion magnet sometimes exerts a sufficiently weak influence that the ratio can stay out of balance for several months to at least two years, as was the case during 2002-03. As unlikely as it may seem in the context of continued volatility in today’s session, the odds favor the SPX:VIX ratio being back in the 100-120 range in the next two months – and this sets up a number of potentially interesting trades.

Volatility Aces Bloggers

A month ago Adam Warner of the Daily Options Report and I had the bright idea to debate where volatility would trade during this past extended options cycle.

Adam made a strong case for lots of dead time during the options cycle leading to lower volatility, perhaps as low as single digits. I took the easy way out and predicted that volatility was most likely to remain in the 12.50 – 15.00 range that it looked like it was settling in to at the time.

Well…if this were tennis, we would be talking something like 6-1, 6-0, 6-0, with volatility taking the two of us out in straight sets and sending Bud Collins (not pictured) officially into retirement. As the VIX chart below shows, volatility spent almost the entire options cycle in the 15.00 – 19.00 range, with the 15.00 resistance that I was counting on a month ago now looking like support. And this is the bigger story.

Nobody should be surprised that we whiffed on our volatility forecasts, as long-term volatility forecasting is extremely difficult. With an additional month of hindsight, however, 15.00 now looks suspiciously like a floor in this all-important volatility measure. If this turns out to be the case, then I can safely say we are entering a new era of increasing volatility. In fact, I think it is just about time to update the long-term VIX chart I offered up on my first post on this blog some 6 ½ months ago by adding a fifth macro period. Ironically, as it turns out, this new period of increasing volatility neatly coincides with the life of this blog. You don’t think…? Nah.

Coming Soon…

There are really only four places where I can consistently brainstorm at the top of my game (a free VIX factoid for anyone who can guess all four of them) and one of them is on long airplane rides.

Since swapping the nomadic consulting lifestyle for that of the geographically constricted stay-at-home trader/investor, I sometimes find myself missing those six hour coast-to-coast flights where I could point my brainwaves in a particular direction and free associate without fear of interruption. Yesterday I had one of those rare opportunities for brainstorming at 38,000 feet and from that session comes a number of ideas that I will likely be talking about in this space in the next two or three months.

Among the subjects that I will be taking a closer look at, in no particular order:

• Looking at volatility across the full range of asset classes (not just US equities)
• Long-term volatility forecasting
• Diving deeper on the correlation between the SPX and the VIX (short-term and long-term)
• Non-VIX volatility measures for the SPX/SPY (ATR, Bollinger Band width, etc.)
• VIX implied volatility vs. historical volatility
• With hurricane season upon us, it is time to look at hurricane-related volatility in drillers, refiners and oil services companies. What are the investment opportunities? How do they mirror the VIX?
• Revisiting the idea of a VIXdex
• How to parse the universe of volatility events -- and maybe flesh out my ideas on a "taxonomy of fear"
  
• Is there a fat tails inflection point? Is there an options tipping point where mean reversion battles new money?
• Fear vs. volatility: Is it meaningful to talk about these subjects separately?
• Develop a Long Term Capital Management timeline superimposed on the VIX

If readers have any particular areas of interest they would like to see me elaborate on, just note them in the “Comments” section below and I’m sure that some of them will get thrown into my R&D queue. Also, if readers have pointers to some interesting work already done in some of my target areas of interest, I would love to hear about these as well.

The Language of the SPX:VIX Ratio

A fellow blogger at The dk Report inquired about the analytical value of the SPX:VIX ratio and what it may be telling us at present.

The simple answer is that I don’t know…but I’ll see if I can articulate my uncertainty a little more eloquently in the space below.

Taking a step back, the reason I first even bothered to mention the SPX:VIX ratio on this blog was to address some comments by Ron Sen at Technically Speaking, who blogs about the SPX:VIX ratio on a regular basis and asked rhetorically back on February 19^th if this ratio was an effective risk metric. My rejoinder was that it does not make sense to compare a trending number like the SPX with an oscillating number like the VIX. Given that the long-term gains in the SPX approximate 10% per year, I somewhat flippantly suggested that a 10% trend line might be added to this ratio. Having tossed this idea out, I proceeded to look for some insight using the distance between the ratio and the trend line in the wake of February 27^th and again when the markets seem to have settled down a month later.

Regarding the 10% trend line, however, I would be remiss in pointing out that my choice of the 10% value was relatively arbitrary (though supported by Ibbotson data) as was my selection of a starting point for the trend line, which turned out to be the default setting for a StockCharts.com monthly chart I created at that time. I used September/October 1991 as a starting point; if you use a different starting month, you can come up with a substantially different trend line.

While keeping one eye on the SPX:VIX ratio, in the last several months, I have spent more of my time and energy researching various correlations between the SPX and the VIX – and will present some findings and interpretations on this subject in the near future. I have already posted about one finding: that when the SPX and VIX are highly positively correlated for short periods of time, this does not augur well for the markets.

High on the priority list for my one man R&D department is to develop a model for long-term volatility forecasts. The VWSI and mean reversion analysis that I have relied heavily upon to this point is best suited for a 5-10 trading day time horizon, though they are sufficiently robust to be applied out to about 20 trading days. It is possible that an analysis similar to that of the SPX:VIX plus a 10% trend line might be appropriate for long-term volatility forecasting, but this remains to be seen. I will also look to tweak the VWSI in order to enhance its predictive power going out 1-3 months. I consider the VWSI and mean reversion to be excellent tools for trading during the current options cycle, but in terms of volatility, I think the Holy Grail lies in being able to look out a quarter or two. This will certainly be an area I look at closely going forward. As always, I encourage reader input.