Volatility
Thursday, March 18th, 2004 9:00pm EST
Extreme Volatility Expectations
Bottom Line: Over the past week, the VXO has experienced a tremendous amount of volatility – historically, that type of activity has lead to good longer-term gains.
In a comment last weekend, I mentioned that the VXO (the ticker symbol for the “old” VIX formula) had flipped by 10% in opposite directions on Thursday and Friday of last week. We’ve now seen a 10% move in the VXO for 5 out of the past 7 days, which is a near-historic level of volatility. In fact, it has been seen only twice before – October 1987 and October 2000 – and both ultimately proved to be dramatic turning points in the market. As a reminder, this data only goes back to 1986, so we are somewhat limited with how far we can go back.
Such short-term bouts of volatility have been positive for the market in the past, at least in the short-term. Even the instance in October 2000 lead to a 2.5% gain over the next 10 trading days before the bear market resumed in full stride. If we relax the parameters a bit and look for those times in history when we’ve seen at least 4 out of 7 days with a VXO movement of 10% or more, then we come up with 11 distinct occurrences (there are actually 39 days which match this phenomenon, but many of them overlapped, such as in 1987). Looking at the performance of the S&P 500 futures 10 days after each occurrences, the futures were higher 8 out of the 11 times, with an average gain of 2.9%. After 30 days, the results were almost exactly the same – suggesting there was a period of consolidation after such violent movements. Looking out 60 days, the futures were positive 9 times, with an average gain of 7.0%.
Market lore tells us that market bottoms are formed in violence while tops are peaceful processes. I don’t subscribe to that line of thinking (I can find too many examples against it), but historically it has proven out that extreme changes in expectations of future returns has portended good market performance a good amount of the time. As I stated above, whenever we have seen such extreme changes in the CBOE implied volatility measure, it lead to a positive market 9 times out of 11. Even accounting for the fact that we were in a major bull market much of that time, the record is impressive.
Conclusion
There is not much new to discuss tonight that I haven’t already gone over during the past week. On the positive side, we have seen extreme volatility swings, puts have been strongly favored over calls from the options crowd, Rydex traders are betting against this rally continuing, recent TRIN readings have been truly historic and specialists continue to buy large amounts of stock. Points against a further advance include the fact that we are still seeing high levels of bullish opinion in many of the sentiment surveys, most longer-term breadth measures are still in the process of correcting their extreme overbought conditions, volatility measures are nowhere near where other good bottoms have formed recently (on an absolute basis, anyway), mutual fund cash levels continue to drag along near historic lows (though this fact is tempered somewhat by the low level of short-term interest rates) and short interest in NYSE issues is on the lower end of its recent range. It all adds up to a pretty muddled picture from a sentiment perspective, and it makes me want to continue to refrain from making aggressive longer-term bets on either side of the ledger.
Shorter-term, I believe there is still room for the market to work off the extreme pessimism we saw over the past week. Many of the readings we were getting were truly historical, and often lead to more of a bounce, even during severe downtrends. My preference for the time being remains with the long side. If we move below last week’s lows, however, all bets are off.
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosure: no positions
This disclosure is not intended as trading advice in any form. It is meant as a note to subscribers that the author may have a position directly affected by the market outlook reflected in the commentary. Although the author takes great pains to remain objective in any commentaries, it is only fair that readers should know that the author may have taken positions in accordance with his market outlook. Positions can and do change at any time, without notice to the reader.
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