Good Economic News for the Holidays: Volatility Is Down

One of the most important but underreported financial indicators is the CBOE‘s Volatility Index (^VIX), which measures the market’s expectation of future volatility in stock prices. (The CBOE has written a nice technical white paper describing how it is calculated, here.) Traditionally, the annualized volatility of the S&P 500 has been 20 percent, but last month when I went to give a talk on retirement investment at Columbia, the VIX was standing at an apocalyptic 80 percent. The huge drop in stock prices is bad, but it would be a lot better if the market thought that the major gyrations were mostly in our past.

So the good news is that the volatility index has retreated to 45 percent:

INSERT DESCRIPTION

Now, 45 percent is still more than twice what it “should” be. But it’s at least moving in the right direction. When it drops below 30 percent, it will be a strong indication that the market correction is complete and we’re back to business as usual.

A group of “chartists” — and I use that term disparagingly — attach a more mystical meaning to the recent decline, relating it to the “golden ratio” and Fibonacci sequence. For example, an article last week on Reuters trumpeted “US-VIX falls below key Fibonacci retracement level” :

The CBOE Volatility Index .VIX fell more than 10.7 percent to as low as 44.50, below a key 61.8-pct Fibonacci retracement level of its surge from late August to late October. Traders could next eye 42.16, the interim high seen shortly after the Lehman collapse.

Why is 61.8 percent key? It comes from the Fibonacci sequence of numbers — which starts with 0, 1 and then adds the two proceeding terms, so it’s 0, 1, 1, 2, 3, 5, 8, 13, 21, 34, 55, 89, 144, etc. A very cool property of the sequence is that the ratio of any number greater than 5 in the sequence divided by the subsequent number in the sequence comes close to 61.8 percent (the reciprocal of the golden ratio).

Chartists look for FIBs. After a major price movement, technical analysts (i.e., chartists, people who think they can predict future stock price given the curve of its past prices) look for reversals equaling 61.8 percent, 50 percent, 38.2 percent, and 23.6 percent as moments where the price is more likely to change again (or not, if the price is powering through to another FIB). Why are these other percentages FIBs? 38.2 percent = 61.8 percent squared, and 23.6 percent = 61.8 percent cubed. Fifty percent isn’t really related to Fibonacci at all, but chartists think they see it in the data.

The golden ratio may exist in nature and art, but Fibonacci retracement strikes me as nonsense on stilts as applied to finance. I’m not as convinced by the short-term, random-walk hypothesis as I was in the days before programmed trading. But there is no reason in the world why Fibonacci retracement should characterize the pricing of a competitive market for information.

Leave A Comment

Comments are moderated and generally will be posted if they are on-topic and not abusive.

 

COMMENTS: 14

View All Comments »
  1. Andy says:

    Please don’t tell me that you mentioned the VIX as being important in your talk on retirement. It is absolutely irrelevant to investing.

    Thumb up 0 Thumb down 0
  2. Drew says:

    The VIX has fallen on extremely low volume, making its pullback much less significant. Of course there’s lower volatility when there’s almost nobody trading. It wouldn’t be surprising at all to see it jump back up at the beginning of next year, once people start putting their money back into the market.

    The fact that the market is trading sideways on almost no volume isn’t “good economic news”. It’s an indication nobody is interested in making significant moves is the market right now.

    Thumb up 0 Thumb down 0
  3. Mitch says:

    While I agree that, in the long run, these numbers are largely nonsense, they aren’t being trumpeted by anyone with a time horizon much longer than a few weeks. That’s not investing; that’s trading. And traders are more than willing to risk money at what they deem to be “key” levels.

    Thumb up 0 Thumb down 0
  4. G Chan says:

    Regarding the retirement investing notes, I think such a high equity allocation is a *terrible* idea in practice. One person has tried it, with disastrous results:
    http://www.bogleheads.org/forum/viewtopic.php?t=5934

    In particular, it does not consider dangers such as:
    A- Record-breaking movements in the stock market. (Don’t you think that old records might be broken?)
    B- It ignores human psychology. When there is a significant drop in the stock market, some people will panic and sell their stocks. This makes it much more difficult to hit their retirement goals.
    Or, conversely, they may double down their investments (multiple times, credit permitting). This greatly increases the risk of defaulted debt and is likely not beneficial to society.

    Thumb up 0 Thumb down 0
  5. social historian says:

    Dear Andy;

    I would take it somewhat seriously. It is part of the picture, not all of it.

    Thumb up 0 Thumb down 0
  6. Sweth says:

    @Drew — Why would lower volume result in lower volatility? The fewer the number of data points (i.e. individual trades), the less applicable the law of large numbers becomes and the more influence individual outliers will have on the distribution; in that scenario, I’d expect more volatility, not less. I’m not as familiar with equity markets as with the bond markets that drive mortgage rates, but in the latter arena, we always assume that low-volume periods are going to be high-volatility ones, and I can’t remember the last time that that assumption didn’t hold true.

    Thumb up 0 Thumb down 0
  7. baba says:

    The theory behind the fibonacci is that it is found a lot in nature and since humans and human activity is part of nature, it should manifest in the stock market.

    While you disparage “chartists”, they would have been out of the market based on simple technicals. The financial markets are the greatest scam for the common public and the US economy is the greatest Ponzi scheme. It is dissapointing, Mr. Ayres that you are propogating the myth.

    Here is a simple rule that will keep you from losing (tons of) money in the markets and will help you make a decent money and is better than your pathetic report at Columbia.

    Buy when the 50 day simple moving average crosses the 200 day SMA. Sell when the 200 day SMA crosses the 50 day SMA.

    Thumb up 0 Thumb down 0
  8. Kieran says:

    If you have hundreds of traders with enough money to move the market looking at the same data, using the same levels as their measuring sticks, these levels matter. It doesn’t matter whether they “should characterize the pricing of a competitive market,” because they do.

    Thumb up 0 Thumb down 0