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:

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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.


Andy

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

Drew

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.

Mitch

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.

G Chan

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.

social historian

Dear Andy;

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

Sweth

@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.

baba

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.

Kieran

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.

John

Some technical indicators can be important if enough traders are paying attention to them that they can influence the way the market works.

For instance, in very short time horizons (minutes/hours), the price of stocks moves more in accordance to the way traders make it move than any kind of fundamentals. In these situations, technicals might matters. Other traders will be like, oh, ADX is strong & RSI is above 50, I might buy here. Over longer periods, fundamentals will come more into play and those relationships won't matter as much.

That being said, Fib on VIX over a daily/weekly chart doesn't really matter much at all.

Mark

I believe VIX on 1mth S&P 500 options are lower, but implied volatility remains high on longer-term contracts.

So it appears volatility expectations were lowered for December/January, but are still fairly high after that.

Mark
http://www.planbeconomics.com

Bob

By the way Ian.. the low in the S&P 500 on November 21st, was targeted (predicted) on November 4th (a full 17 days in advance) as a 1.272% Fibonacci extension down of the last swing off the October lows. Guess what Ian - it hit that extension on a dime and turned. When everyone else was freaking out because the October lows were taken out - I, as a frayed collar technician went in and sold VERY overpriced puts ANOTHER standard deviation BELOW the November lows. The probability on the trade was extremely high. I shut the trade down two weeks later for massive profits - how'd you fare during that period?

I manage money professionally for private clients and institutions. I am up 29% for the year - using - you guessed it - technicals, fibonacci and options. Just because you don't know how to make money in the markets Ian doesn't mean others can't. Trading is not about being right on every trade. Its about risk management and probability. It's pure, objective math - nothing more.

Investors have been sold the, "BUY, HOPE and PRAY" mantra too long by the self serving financial services business. It's all about trailer fees and commissions right Ian? Now they're down 40% for the year - and advisors have no idea what to do next. Sell'em more mutual funds! Think my returns are a fluke?... I'm up 90% over the last three years. Guess what - my clients love me. Email me - I'll send you my brokerage statements.

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social historian

Dear Bob;

You are a bit above my head and I have not the time to sort out your thoughts. But I will ask you this one question. What questions should one be asking a money manager who manages a family member's money.

Antonio S

To start, "volatility" is a function of variance. Variance is a MEASURE of random variables, not an inherent property of assets. It is been widely proved that assets prices exhibits fat tails, which by definition means variance does not converges (variance does not exists!). Thus VIX is just a fun thing to look, not an "estimator"

fati

said the crisis world economic until 2015
http://news-economic.blogspot.com