VWSI at +4; Next Bump Soon?

So what’s with the round numbers? Surely the conspiracy theorists know that prior to last week the VIX had closed at a round number only 9 times in 18 years. Now that we have back to back closes at 19.00 and 18.00 the stars must be aligning for something. But what?

The VWSI, which is registering a reasonably elevated +4 on the heels of last week’s +6, thinks that a significant VIX spike is just around the corner. Back to back positive readings of this magnitude in the VWSI are extremely rare and with volatility below just about every moving average, this appears to be a good time to consider lightening up on equities and getting long volatility.

With the VIX dropping exactly one point (5.3%) this week to 18.00, we are now down to the lowest end of week reading in ten weeks. Like I said last week, with all the headline risk, the VIX looks like fairly cheap portfolio insurance.

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For a VWSI of +4 I heartily recommend a riesling. As a matter of fact, riesling is a wine that goes with just about any VWSI. It is versatile food wine that comes in a wide variety of styles, from bone dry to the sweetest of dessert wines . Frankly, this wine deserves to be more popular than chardonnay, but, at least in the United States, riesling’s stature has been weakened by too many associations with middling off-dry versions of the varietal.

German-speaking readers can find a wealth of information about riesling at Riesling.com; those who rely on English will have to be content with the likes of Riesling Report.

In terms of top producers, all of my comments about Alsatian gewurztraminer producers apply to riesling as well. For an exemplary California riesling I can highly recommend Trefethen Riesling from Napa, a wine that Eric Asimov of The Pour (New York Times) first brought to my attention earlier this year. This wine is a steal for $16 at my local wine store.

Volatility Index Options Menu Expands: VXN and RVX Options Now Available

When I started this blog, one of the reasons I decided to call it “VIX and More” was that unlike other options indices, it was possible to trade VIX options. Well…I won’t be renaming the blog, but as of yesterday, the CBOE is now trading options on the VXN (NASDAQ-100 Volatility Index) and RVX (Russell 2000 Volatility Index.)

I reported on this development when it was first announced and recently offered up some graphs on comparative performance of the major US volatility indices, but clearly it is time to update the full volatility options tree.

With the new VXN and RVX options, the US volatility indices now stack up as follows:

Additionally, the CBOE has added a new splash page for all five of the volatility indices, which I have pinned to the upper right hand corner of the blog.

The CBOE has also used the occasion of the launch of options on the VXN and RVX to provide some data on these indices that may be of interest to readers. I found it particularly interesting that in terms of activity in the futures (launched July 6, 2007), investors have so far favored the RVX to the VXN by a large margin:

Perhaps related to the above, while a graphic published by the CBOE shows that the VIX has a stronger (negative) correlation to the SPX than do the other volatility indices to their counterparts, it also seems that the relationship between the RVX and the RUT is stronger than that of the VXN and the NDX:

Finally, those interested in implied volatility for the new options can click on the RVX and VXN links to get the appropriate information and graphs from iVolatility.com. From a historical volatility perspective, these two indices look fairly similar at the moment, but I will keep a close eye on them going forward and report any noteworthy divergences.

Historical Volatility and One Year Returns

When speaking about options, I have a habit of glossing over historical volatility and focusing on implied volatility. After all, implied volatility is the basis for the VIX calculation and historical volatility, well, for the most part I tend to regard it as a historical artifact that may or may not provide some insight into the current level of IV.

TradingMarkets.com, however, had some very interesting things to say about historical volatility in an article published last week that bear repeating here. In an article co-authored by Larry Connors (to my knowledge, the only person who has published a book [out of print, unfortunately] dedicated exclusively to the VIX: Trading Connors VIX Reversals), TradingMarkets.com presents their research on 100 day historical volatility patterns and subsequent one year performance for 11,000+ stocks from the period 1995-2007.

Their conclusions may surprise many traders and are certainly worth pondering. In looking at buckets of the 10% and 20% most volatile stocks and comparing these to buckets of the 10% and 20% least volatile stocks, the authors determined that the least volatile stocks were almost twice as likely to be trading higher one year later and, on average, had one year returns more than double (14.7% to 7.3%) their high volatility counterparts.

As an interesting historical footnote, Connors and co-author Cesar Alvarez point out that the lower volatility buckets outperformed the higher volatility group for the entire period studied, with the exception of the middle of 1998 through 1999, during which time the dot com boom phenomenon overrode the tendency for the higher volatility stock to be the laggards. Of course, if you were to remove this period from the study and focus on the remaining 11 years, the superior performance of the lower volatility stocks would be even more impressive than the statistics quoted above.

So the next time you make a lot of money trading those high volatility stocks, make sure you put your profits into a low volatility long-term portfolio…and if the high volatility stocks start to outperform their slow and steady cousins, consider a defensive portfolio. [Bonus points to any reader who comes up with the best ratio chart available on StockCharts.com for comparing high volatility stocks to low volatility stocks.]

VIX Oversold

At 17.48, the VIX is now 17% below its 10 day SMA and 24% below its 20 day SMA, levels not seen since the end of June 2006. While I am not going to predict that the VIX will jump 43% over the next ten days like it did the last time it was this far below the two SMAs, history suggests that the VIX will start moving up from here and that the broader indices, some of which are approaching previous highs, are due for a selloff.

For the record, the chart below show the VIX with respect to its 10 day simple moving average, with the dotted green lines tracking +10% and -10% from that SMA and the solid green lines indicating the +20% and -20% levels from the 10 day SMA. As a general rule, mean reversion is increasingly likely the farther the VIX strays from the 10 day SMA.

I am inclined to think that the new floor in the VIX for the next month or so will be in the 16-17 range, but that is no more than a guesstimate. How the various sentiment indicators act as we test old highs will tell us a lot about the strength of this decidedly long in the tooth bull. Better not to anticipate, but to prepare for several different contingencies – and keep an eye on the VIX for some clues.

Also, apropos of yesterday's commentary, while the DJIA may be +80 at the moment, I note that many of the recent momentum stocks are in the red: BIDU, GRMN, LVS, BCSI, FWLT, MA, FSLR, AAPL, FCX, PCU, CMI, etc. Keep an eye on this development too.

BIDU: Hogs (Eventually) Get Slaughtered

As I write this, BIDU is trading at about 301, meaning that if you got in near the August 16 low, you may be sitting on a 140 point profit.

I was indeed fortunate enough to grab some BIDU on August 16^th, though nowhere close to the day’s low of 161. Over the course of the past few weeks I have been taking profits, with less than 10% of my initial position remaining after selling some earlier this morning.

As I was selling some shares, it occurred to me that it might be time to update my watch list of “Overripe High Fliers.” This is a list of ten momentum stocks that I keep a close eye on and expect to provide some clues about speculative activity. These stocks should be strong when the market is rallying and move sharply down when the market turns down. The list currently consists of AAPL, BCSI, BIDU, CROX, DRYS, FSLR, GRMN, LVS, RIMM and VMW.

In keeping with Amazon’s “people who bought X also…” approach, optionsXpress has a tool that tells you what people who traded BIDU were also trading. The results, in the graphic below, could easily be an updated list of those “Overripe High Fliers.” Consider that when BIDU finally makes a sharp turn south (and I expect a -20 day soon), the rest of the stocks on this list will probably be dumped with the same bath water. Contrarians, aim your guns at these targets.

…and don’t count on the nearly vertical rise in BIDU to continue much longer. As a general rule, the steeper the rise, the more spectacular the fall back to earth.

VIX:SDS Ratio a Keeper?

I’ll be the first to admit that I keep track of a boatload of silly VIX charts (hey, it’s better than a house full of cats…) that no person in their right mind should ever bother with, but every now and then one speaks to me in a convincingly enough fashion that I keep going back to it.

So here I am with the VIX:SDS ratio chart again. Alan Greenspan says that the holy grail of market forecasting is a fear vs. euphoria indicator. Frankly, this one is good enough for me – at least for the moment. Given that the SDS ETF has only been around since July 2006, there is little in the way of historical information with which to do some backtesting, but I like how the VIX:SDS ratio has been acting during the recent market action. The ratio may not be a perfect way to decompose the fear and volatility components of the VIX, but it certainly offers a fair share of clues. One way to look at the current reading, for instance, would be to interpret only a small fear premium built into the ratio vis-à-vis the more ‘normal’ sentiment expressed by the 100 day SMA.

If anyone has thoughts on this indicator – pro or con – feel free to use the comments section below to make your opinion heard.

Portfolio A1 Continues Upswing Behind Red Hot Mosaic (MOS)

Thanks to the Fed rate cut, three of Portfolio A1’s five holdings logged gains of 10% or more last week, led by a 12.2% gain in The Mosaic Company (MOS), which now sports an impressive 39.7% return in the five weeks it has been in the portfolio. Also part of last week’s winning trio were DryShips (DRYS) and Navistar (NAVZ). By the time the abacus was put to bed, the gap between the benchmark S&P 500 index and the portfolio had closed to 7.9%, the lowest margin since the mid-August plunge. With a total return of -3.08 since the February 16, 2007 inception, it is beginning to look like the portfolio may soon be back in green.

In the never ending quest for better performance (while keeping a deaf ear to any concerns about high turnover) this week the stock ranking system has jettisoned Sanderson Farms (SFM) in favor of Terex (TEX), an infrastructure play with significant exposure to China. A returnee, Terex was a very strong contributor to the portfolio earlier in the year.

There are no other changes to the portfolio this week.

A snapshot of the portfolio is as follows:

VWSI Jumps to +6 on Rate Cut

It took 25 trading sessions for the VIX to shed half of the excess baggage it had accumulated by the August 16 intra-day high of 37.50. Thanks to the Fed’s larger than expected rate cut, not only is the VIX looking like a competitor from The Biggest Loser, but Friday also marked the first day since July that the VIX spend the entire day in the teens.

The VIX dropped 5.92 points or 23.8% this week to end the week at 19.00, but consistent with the volatility roller coaster theme, this was only the third largest weekly drop of 2007. The drop was enough to turn the VWSI around, however, pushing that indicator from -1 to +6. The VWSI has only registered an end of week reading of +6 or higher five times since 1998, with four of those five instances seeing a significantly higher VIX over the next few weeks.

I’ll offer up one additional factoid to think about. Consider the current investment climate and consider also that at its present level, the VIX sits a mere 0.07 above its 17+ year lifetime mean. To my thinking at least, the VIX is once again looking like fairly cheap portfolio insurance…

(Note that in the above temperature gauge, the "bullish" and "bearish" labels apply to the VIX, not to the broader markets, which are usually negatively correlated with the VIX.)

Wine pairing: For a VWSI of +6 I favor a semillon. This often overlooked varietal tag teams with sauvignon blanc to form the white wines of Bordeaux, otherwise known as Graves. The thin skinned semillon grape is particularly susceptible to the Botrytis fungus, which means that semillon is also the primary grape used in the classic dessert wine known as Sauternes.

In the New World, semillon has gained a strong foothold in Australia, where it is frequently blended with chardonnay and sauvignon blanc, but also sold on its own. Last I checked, Peter Lehmann Wines produces four different semillons, with the Barossa Valley one of the most widely distributed in the US. Skipping a little to the east, just this evening I had an excellent 2002 Alpha Domus semillon from New Zealand, but the Kiwis have yet to show the same enthusiasm for semillon that they have for sauvignon blanc. Still, the Alpha Domus effort proves that the potential is there.

It is harder to pick a particular US producer that has built a reputation for semillon, but one to keep an eye on is L'Ecole Nº 41, from the Walla Walla, Washington area.

For more information on semillon, StarChefs.com has a good discussion of the varietal, along with a handful of recommended producers in Australia and South Africa.

Alan Greenspan on Fear and Euphoria

The clip above is from a provocative interview with Jon Stewart of The Daily Show (tip of the hat to Jack Stevison.) Note that at the end of the interview Greenspan has some very compelling things to say about subjects related to fear and, by implication, the VIX. Maybe Alan needs to spend more time on this blog...

"The problem is: periodically we all go a little bit euphoric, until we get to the point where we are effectively assuming with confidence that everything is terrific, there will be no problems, nothing [bad] will ever happen. And then it dawns on us: no!

...I've been dealing with these big mathematical models of forecasting the economy and I'm looking at what's been going on the past few weeks and I say, you know, if I could figure out a way to determine whether or not people are more fearful or changing to euphoric and have a third way to figure out which of the two things are working, I don't need any of this other stuff. I could forecast the economy better than any way I know. The trouble is that we can't figure that out.

...I've been in the forecasting business for 50 years...I'm no better than I ever was and nobody else is. Forecasting 50 years ago is as good or as bad as it is today and the reason is that human nature has never changed. We can't improve ourselves."

Reflections on Investing Ten Years Ago

Yesterday I happened to be rummaging through some old files and came across my 1997 tax return. Fortunately, this had nothing to do with any communications with the IRS, but it got me to thinking about how my investing ‘evolution’ has three distinct long-term phases. Specifically, for the first ten years of my investment life, I dabbled in equities with mixed results at best, in much the same manner as Nicholas Darvas describes his early floundering in How I made $2,000,000 in the Stock Market.

Deciding that the time and effort was not worth the lackluster results, I pushed my savings into mutual funds for the next five years or so, again with fair to middling results. I got a little ornery and started chasing momentum funds like those from PBHG and Van Wagoner, but ultimately concluded that it might be possible for me to try to mimic what they were doing by buying individual stocks on my own.

[As a side note, Gary Pilgrim (PBHG) and Garrett Van Wagoner ended up having more than their share of difficulties, but their approach inspired me to aim higher than beating the S&P 500 by 1.0% point each year.]

To make a long story short(er), the third phase began in 1997 when I decided to go ‘all in’ on a portfolio consisting entirely of internet stocks. While that may not sound all that surprising with the benefit of hindsight, very few investors were buying any internet stocks at the time and frankly there were not that many choices out there. I reasoned (and yes there was some hope involved too) that if most of the technology changes that were being touted at the time came to fruition, it could be a once in a lifetime investment opportunity.

So…I made the type of decision in 1997 that many others would make in 1999 and early 2000. What happened?

In retrospect, I might have done better plowing my money into the Munder NetNet fund (now the Munder Internet fund), but instead, I picked five small and very speculative companies that I thought had a chance to be big home runs if things went my way. The first two companies I started buying up were content plays. If content was going to be king, I wanted to own the king makers. Both of my selections are still alive and kicking: BroadVision (BVSN) had a meteoric rise and then crashed back to earth, Icarus-style; Open Text (OTEX) has led a comparatively uneventful existence, growing slowly and steadily to its current $1.3 billion market cap. My third choice was CyberCash. I expected that someone like PayPal would eventually dominate the electronic payment business with the type of ‘increasing returns to scale’ (described by Brian Arthur, among others) as the industry standard, but alas it was not to be CyberCash, which eventually declared bankruptcy, had its assets sold to VeriSign, with the CyberCash intellectual property eventually ending up at PayPal via an acquisition. In the VoIP communications space, I bought VocalTec, a company that released what I believe was the first internet VoIP program. Now a $16 million also ran (still listed as VOCL, for the record), they even had something called – of all things – the IPhone out back in 1995. Sometimes you can recognize the pioneers by the arrows sticking out of their back... For whatever reason, I felt most confident in the fifth ‘internet stock’ I started buying. Check Point (CHKP) has been a leader in firewall and related security products in the ten years since I first started buying the stock. An Israeli company like VocalTec (for the record, Open Text is Canadian; BVSN was the only Silicon Valley company, as CYCH was headquartered in the Virginia suburbs, just outside of Washington D.C.), Check Point has grown to become a $5.4 billion company, but has always operated in the long shadow of a strong Cisco competitive threat, with this 1998 Check Point press release typical of that battle that has been fought.

So enough of the nostalgia. For those who may be interested, I did hold BVSN all the way to the 2000 top – and then some of the way down. I was out of the other four within a year. In retrospect, CHKP and OTEX turned out to be solid if unspectacular investments; CYCH and VOCL were the two dogs.

I’m not sure exactly what the lesson is here, if any. In 1998 I went on to pick a lot of winners in the internet space – and a lot of dogs. I have always been patient enough to let my winners run, but over the years I have continued to improve my ability to cut my losses quickly and protect my profits for those trades that make a big U-turn. If I had been fortunate enough to have read the likes of When to Sell, written by Justin Mamis in 1977, and It’s When You Sell that Counts, a 1991 classic from Donald Cassidy, I’m sure those early internet years would have been considerably more profitable. In the long run, each individual learning curve has different hurdles and a different timetable. The trick is to get a little smarter every day, even if your portfolio does not always reflect all newly acquired wisdom.

Party Like It’s 1996?!?

Time for an informal poll again. Raise your hand if you keep track of VIX SMAs going back more than 20 days. What about SMAs going back 1000 days? You may think I’m crazy (sometimes I like to pretend to be crazy just to be a little more provocative, so consider the possibility that I’ve merely intentionally unhinged my brain for awhile,) but if you put any credence in the idea of VIX macro cycles and think it is possible for VIX cycles to last 2-4 years, why not look at the VIX’s long-term moving averages?

When thinking about the current investment environment and the year it most closely resembles, one year I do not recall any reference to is 1996. Look at the chart below and consider that 1996 was not a bad time to initiate an aggressive buy and hold strategy. Do you remember what Yahoo looked like in 1996? No, not the stock (which opened at a split-adjusted 1.05 in April and could be had for 0.64 in July), but the 1996 Yahoo web site.

Continuing the wayback machine theme, coming tomorrow: what I was buying in 1997 and why I was buying it.

On the Rarity of a 20% One Day Drop in the VIX

Back in February and March, the wild swings in the VIX inspired me to write extensively about my research into VIX spikes and topics related to volatility extremes. Most of these are spikes higher, as fear is not something that is usually extinguished during the course of a single trading session, just as one slain dragon is not likely to put a village back at ease. After all, what is that the chance that there was only one dragon out there?

There was an instance, however, in which the VIX nearly dropped 20% in one day in March, prompting a retrospective look, at the three previous instances of single day 20% drops in the VIX that I titled “Elast-o-VIX.”

Now that I know enough blog-related HTML to be dangerous, I have updated that earlier graph and added second graph that depicts yesterday’s 23% drop in the VIX in the context of the past week. If the past is prologue, then does it matter if the current VIX drop was not preceded by a VIX runup of similar proportions? That remains to be seen, of course. Past instances notwithstanding, the VWSI currently stands at +4, suggesting that the VIX is more likely to move up from here rather than down in the next week or two.

[With only three previous data points to draw upon, I feel compelled to note that we are a long distance from anything resembling statistical significance, but sometimes historical voyeurism is more interesting than statistical significance, particularly when we are talking about once or twice a decade events.]

Rate Cut Projections

Charts courtesy of the Cleveland Fed's web site:

Fireworks Forecast for the Next Few Days

It doesn’t take a lot of courage to predict fireworks in the markets following tomorrow’s Fed announcement, but it is interesting to wonder which stocks will be the biggest movers.

A scan of some of the stocks with the highest implied volatility tells a good part of the story. From the group below comes some obvious choices, such as home builders and lenders. There are also two Chinese companies, including one in the red-hot solar sector, as well as various natural resources plays in gold, oil/gas, and dry bulk shipping. Then, of course, there is the VIX itself.

[The chart above includes only front month at the money options with an IV of 70 or more and a relatively low bar for volume and open interest.]

For the record, the current VIX IV is right in the middle of the 52 week range and has been below 30 day historical volatility for the past month or so.

I have included a Yahoo finance link to all nine high IV stocks (actually eight stocks and the VIX, but who’s counting…) for those who like to play with fire. As I write this, I’ve begun to wonder whether traders are more likely to have been pyromaniacs as children. Hmmm. Are traders more or less prone to having risky hobbies? Lurkers, feel free to weigh in on this one.

DRYS Slows Portfolio A1’s Advance

After rallying impressively over the past three weeks, Portfolio A1 lost momentum last week, due in large part to a 8.5% decline for the week in DryShips (DRYS), after JPMorgan expressed some concern about the drybulk sector.

With four of the five holdings in the red, the portfolio has relied heavily on fertilizer stalwart Mosaic Company (MOS) for capital appreciation, but even with MOS’s 24.4% one month gain, this one-legged portfolio does not have enough forward momentum at the moment to credibly threaten break even soon. Still, with the FOMC about to make a highly anticipated rate cut decision on Tuesday, anything can happen, even a sustainable surge.

There are no changes to the portfolio this week.

A snapshot of the portfolio is as follows: