New Game, New Rules

Earlier this week, I was thinking about what might qualify as the five most important events in my lifetime. I came up with the following list, which perhaps reflects my personal perspective on the world more than anything else:

1. Cuban Missile Crisis (I was born a little after JFK was inaugurated, so I can’t go back much further in time than this)
2. 9/11
3. Passage of the Civil Rights Act
4. Falling of the Berlin Wall / Breakup of Soviet Union
5. Nixon’s Resignation / Watergate

Not quite making the cut were the first moon landing and moon walk, the creation of the internet, and various other advances in science and technology.

I had wondered if the events of this week would make it on that list. While it is too early to tell, my initial gut reaction is that if the financial markets had a constitution, we have essentially just ripped it up and declared martial law. Things may meander back toward the way they used to be, but I don’t think the markets will ever be the same going forward, given what has just transpired, regardless of what the consequences turn out to be.

Many have written eloquently about recent events, but there are three posts from this morning that I wish to highlight:

• Ron Sen at Technically Speaking pulled together a “partial list of entities responsible for the financial mess” in Puff the Magic Dragon
  
  
• David Merkel at The Aleph Blog outlines some of the effects of eliminating short sales in Government Policy Created too Hastily
  
  
• Adam Warner at Daily Options Report details some of the ways that investors can still make bearish bets, without the benefit of shorting in Quick Expiration and Bearish Bet Primer

VIX to 42.16...But Will It Hold?

So we have a new line in the sand right now, a VIX of 42.16 (and SPX of 1133).

Note that when the VIX continues to spike to new highs even as the markets are not making new lows, then we have extreme fear.

To answer a question in a post below, there is no reason why the VIX cannot spike above 45 today, though I do not expect that to happen.

In terms of a potential bottom, the big fly in the ointment is the calendar. Tomorrow is options expiration, which is followed by a weekend in which I can't imagine many investors will be comfortable with large long positions. As a result, if the markets do not show some strength in the second half of today's session, they are not likely to be strong tomorrow or Monday morning.

VIX Spikes to 38.32

Moments ago the VIX spiked to 38.32, the highest VIX level recorded in the past six years surpassing the 37.57 VIX spike back on January 22nd.

With the weekend coming up and so much uncertainty in the markets, I am concerned that we may still be several sessions away from a Brunhilde Day. On the other hand, a strong finish today on impressive volume and lots of breadth would help to make the case for an intermediate-term bottom.

VIX:VXV Ratio at New End of Day High

As far as I know, I was the first person to show interest in the VXV as a market timing indicator and the first to talk about the VIX:VXV ratio when I posted on these subjects back in early December in The VIX:VXV Ratio.

Fast forward nine months and the VIX:VXV ratio has an admirable market timing record and a very strong following, here and elsewhere. Last night it set a new end of day high when the ratio closed at 1.20. So far, readings of 1.08 and above have been good long entry points. Using the same logic, a long entry at 1.20 should be an even better trade. I will be interested to see how last night’s signal turns out.

[source: StockCharts, VIX and More]

Volatility Catastrophe Graphic

Catastrophe may not be exactly the right word here, but I needed a title with which to introduce the graphic below, which is a ratio of the VIX to the 3 month T-bill yield (VIX:IRX ratio).

The chart goes back to beginning of the VIX data in 1990 and even in a log scale demonstrates that the current environment is several orders of magnitude more concerning (at least from a volatility and flight to safety perspective) than any other day in the last 19 years.

For more background on this particular ratio, check out Expanding on the VIX and the 10 Year Treasury Note Yield and Fear and the Flight to Safety.

[source: StockCharts]

SPX:VIX Ratio Sets Record for Distance Below Trend Line

There are many extreme numbers being generated by the current panic in the markets. Since this blog emphasizes volatility, I wanted to share one that takes a long-term view of volatility: the SPX:VIX ratio.

In the chart below, I have created a graphic which tracks the ratio back to the first VIX data from 1990. In addition to the ratio (black line) and SPX (gray area chart), I have also included a blue line that represents a 10% long-term trend line for the SPX (for additional information, try The SPX:VIX Relationship). The key takeaway is that the SPX:VIX ratio is now farther below the trend line than it ever has been during the 19 years of VIX data.

Incidentally, the SPX:VIX ratio has been declining steadily since January 2007, some 21 months ago. As long as the 2000-2002 bear marked seemed, the SPX:VIX ratio trended down only three months more (24 months) during that bear stretch.

The SPX:VIX ratio tends to be mean-reverting around the long-term trend line, but as the graphic shows, the path back to the mean can be a long and difficult one.

[source: StockCharts]

Fear and Large VIX Spikes

We are starting to finally see some real fear today, for the first time in a long time.

Regarding fear and large VIX spikes, my thinking is that the setup for a big VIX spike comes only after market participants begin to believe that a bottom is in and a sharp move downward suddenly causes them to change their mind. The mind set switches from something like "it's finally safe to be long again" to something along the lines of "oh no, this is much worse than I though...and I am caught on the wrong side of it."

Part of the fear factor is the fear that something unknown and/or much larger than expected is at work.

CDR Counterparty Risk Index Swamps March High

Credit Derivatives Research has a Counterparty Risk Index (and a number of related sub-indices) which calculates the average credit spread of the 15 largest credit derivative dealers. Following the recent turmoil in the credit markets, the index now stands more than 50% higher than the previous March 2008 high.

Not surprisingly, the Markit CDX (credit default swap) indices are seeing similar spikes.

[graphic courtesy of Credit Derivatives Research]

VIX:VXV Ratio at 1.16

The VIX:VXV ratio spiked to 1.16 at the open today, suggesting a high probability of an imminent reversal of the short and intermediate trends.

Put to call and other contrary sentiment indicators are supporting this reading.

Of course, the market is being driven by news of deteriorating macroeconomic conditions and fundamentals right now, so it may take longer than usual for this extreme sentiment reading to reverse.

VIX Spikes and the 2002 Market Bottom

With the VIX spiking over 30 this morning and investors wondering if the markets will ever find a bottom, this seems like a good time to talk about VIX spikes and market bottoms. Specifically, I want to dispel the myth that bear markets have to end in some grand capitulation climax that includes a dramatic volatility spike.

A perfect counter example to the VIX spike requirement can be found in the bear market that followed the NASDAQ boom which crested in March 2000. In fact, with the exception of the current bear market, the 2000-2002 bear market is the only bear market since the launch of the VIX back in 1993 or the historical reconstruction of VIX data by the CBOE that dates back to 1990.

Rather than use the SPX and the VIX to demonstrate my point, the chart below uses the NASDAQ-100 index (NDX) and its companion volatility index, the VXN. The reason I chose the NDX is that from the March 24, 2000 peak (4816.35) to the October 8, 2002 bottom (795.25), the NDX lost an astonishing 83.5% of its value. If there was ever an opportunity to witness a dramatic drop and capitulation, this was the market and index in which to see it happen.

If one looks at a chart of the NDX and the VXN for the period 2000-2002, five distinct VXN spikes stand out. I have highlighted these with a blue vertical line for easy reference in the chart below. It turns out that those who went long at the time of these volatility spikes saw anywhere from two weeks of a bounce to several months of mostly sideways action. None of these spikes signaled a lasting market bottom.

When the NDX finally hit bottom (marked by the red vertical line and arrow), the VXN barely moved at all. Yes, the nastiest bear market of the last two decades ended with a volatility whimper. I like to call this type of bottoming action a "stealth bottom."

Capitulation comes in all shapes in sizes. Most bottoms are marked by a VIX spike. If, however, you assume that volatility spikes will mark the bottoms and bottoms cannot form without a VIX spike, you will be overlooking an important lesson from perhaps the most important recent bear market.

[source: StockCharts, VIX and More]

Brazil Finding a Bottom?

As I noted yesterday in The U.S. VIX vs. a BRIC VIX, emerging markets have been struggling mightily in the past few months.

An excellent example of the weakness in emerging markets can be found in Brazil, where the Brazil country ETF (EWZ) fell 44.3% from a late May high to a low that was made yesterday. Now picking bottoms is a game best suited for those who are long on hubris and short on common sense, but there are several factors which lead me to believe that yesterday’s low may turn out to be an intermediate or long-term bottom.

From a purely technical perspective, the chart below shows Tuesday as the lowest close (omitted is the intra-day 52 week low from yesterday). Also on Tuesday, EWZ’s options volume hit a new high for 2008 and implied volatility spiked to levels not seen since the March panic. Of course, none of these factors guarantees a bottom, but taken together, and given the relative strength of EWZ once again today (up over 4% as I type this), they increase the likelihood of a profitable entry.

[source: International Securities Exchange]

[Disclosure: long EWZ at time of writing]

The U.S. VIX vs. a BRIC VIX

India has an India VIX, Germany has the VDAX, and some other countries (largely in Europe) have their own country volatility indices. Outside of North America and Europe, the volatility index pickings are slim, however, so when you want to get a sense of international volatility on a broader scale, you have to roll your own.

Which is exactly what I have done today.

In the chart below, the bottom half is a six month chart of implied volatility in the S&P 500 index. It is similar, but not identical to the VIX. Note the March high, a second peak in mid-July, and the recent uptrend in volatility.

On the top half of the chart is the implied volatility in the Claymore BHY BRIC (Brazil, Russia, India, and China) ETF (EEB), which attempts to replicate the performance of the Bank of New York BRIC Select ADR index. In contrast to the SPX, implied volatility in the BRIC ETF was relatively moderate in July, but has spiked dramatically over the course of the past two weeks. In short, fear and anxiety may be rising slowly in U.S. markets, but in the critical economies of Brazil, Russia, India, and China, signs of panic are much more widespread.

If emerging markets are the buffer whose continued growth is supposed to buttress developed markets in this economic slowdown, then emerging markets need to find their own firm ground and soothe anxious investors before they can be expected to lubricate the wheels of the global economy.

[source: International Securites Exchange]

VXN:QID Ratio Reflects Unusual Complacency

With the Fannie/Freddie bailout getting no better than mixed reviews, the U.K., Germany, and Spain apparently headed for a recession, and continuing turmoil in emerging markets, sometimes I am surprised to see any green at all on my screen.

On the other hand, I’m sure some are wondering how close we can be to a collapse in the world’s financial system if the VIX is trading in the 24s.

It’s a valid question – and one I have addressed in the past on the blog with the benefit of several indicators which help evaluate how much complacency is in the market. One of these is a ‘fearogram,’ which measures the ratio of changes in the VIX to changes in the SPX. A similar tool is the VIX:SDS ratio, which compares the relative movements of the VIX and SDS (the double inverse ETF for the SPX) to historical patterns.

Below I have created a chart of the VXN:QID ratio, a sister to the VIX:SDS ratio. This chart compares volatility in the NASDAQ-100 index (NDX) to the double inverse ETF for the NDX. There are (at least) three ways to think about complacency in this chart:

1. the absolute level of the ratio
2. the level of the ratio relative to the 10 day simple moving average
3. the level of the ratio relative to the 100 day simple moving average

Looking at the chart, consider that lower readings generally correspond to lower levels of complacency (i.e., less volatility and fear per unit of decline). The current ratio is moderately low on an absolute scale, but is lodged neatly between the 10 and 100 day SMAs. What I find particularly interesting about the chart is that in those instances in which the VXN has experienced a sustained rise over a period of several weeks or more (see top section of graphic), the current situation is the first time the ratio has not risen on par with the VXN. This development is a divergence worth watching and one which appears to favor the bears.

[source: StockCharts, VIX and More]

Thanks to all who responded to my call for help about creating blog posts in Word and publishing them to Blogger. For the record, this is my first post using Windows Live Writer, which has been up to the task so far...

Treasury Inflation-Protected Securities and Inflation Expectations

First there was the inflation scare, then there was the deflation scare, and now it seems any network or blog can find enough economists to support either scenario as a grave concern for the economy.

In times of confusion, I like to take my cues from the markets. This time around I am talking about the future inflation rate expectations that can be derived from Treasury Inflation-Protected Securities, more commonly known as TIPS. Using the CPI as an inflationary benchmark, TIPS coupon payments and the underlying principal are automatically adjusted to account for inflation. With a couple of assumptions to mitigate a liquidity premium and inflation-risk premium, a market assessment of inflationary expectations can be derived from the difference in yield between nominal treasury notes and TIPS, which is exactly what the graph below shows.

Based on the TIPS yield differential analysis, it appears as if inflationary expectations peaked in either late February or late June and have been steadily trending lower over the course of the past two months, to the point that current inflationary expectations are at levels not seen in at least ten months.

[source: Federal Reserve Bank of Cleveland]

A Technical Aside: How to Best Create in Word and Publish in Blogger?

It has been 20 months since I started blogging and during that period, Blogger has turned out to be a surprisingly reliable platform. Blogger is not without its shortcomings, but all things considered, I have been relatively happy creating posts in Microsoft Word, pasting them into Blogger, and adding the finishing touches with Blogger's own functionality.

Recently, however, whenever I paste something from Word into Blogger, the formatting has not translated properly. At first, I would edit the HTML manually in Blogger, with reasonable results given the effort required. This was an acceptable workaround when most of the rogue HTML code preceded the text of my post and could easily be stripped out in one step. Now the quantity of extra Word-generated HTML seems to be increasing and I find myself left with the option of pasting all the extraneous HTML from Word into Blogger or using an intermediate step such as Word->Notepad->Blogger to strip out all formatting, then reformatting the post and adding all HTML from scratch in Blogger. Neither approach is the streamlined process I am looking for (and enjoyed until recently.)

I have investigated a number of alternatives and have yet to find a satisfactory one. Ideally, I would like to create a post in Word and publish it to my blog in one step, without the loss of any links and formatting I create in Word. There must be some good solutions out there. Readers, what can you recommend?