100 Years of Volatility
Sunday, April 10th, 2005 9:30 am EST
60-SECOND SUMMARY
Even those who tend to not be contrarian in their investment analysis seem to pay attention to the VIX indicator. This measure of “fear” among traders has become one of the most widely-quoted indicators around.
Unfortunately, it has only been around for about 20 years, and about 40% of those years have been skewed by unusual market events. When we compute a good proxy for the VIX and look back over the past century, it becomes evident that what we are seeing now is not at all unusual. In fact, according to history we may see another two years or more before we see another large, protracted spike in the VIX.
We had been targeting the last week in March as a potential turning point, and so far that could still turn out to be the case (at least in the S&P and Nasdaq). Certainly there are some troubling holdouts among our sentiment gauges, but we are 50% long QQQQ now, and will likely add to that on additional weakness.
100 Years of Volatility
Ever since my youth, I’ve had a bad case of myopia, aka near-sightedness. If you take away my glasses, I’m a goner…wouldn’t be able to recognize you if you were standing three feet in front of me.
As traders and investors, we all suffer the same affliction from time to time. We see only what’s right in front of our noses and sometimes miss the larger landscape behind it. I was reminded of that this weekend as I was thinking about volatility, as there has been much discussion of the steep drops and low levels of the VIX and VXN. This is one of those times where I think it really helps to step back, put on a clean pair of glasses, and find out if we’re missing something.
The problem with using the VIX, and especially the VXN, is that they are relatively new measures. And we have just undergone one of the most unusual times in history volatility-wise, so it’s natural for us to have a skewed sense of reality.
The VIX is supposed to reflect traders’ consensus opinion on the S&P 500’s annualized volatility going forward. A current reading of 12.6 means that traders expect that S&P to not move any more than 12.6% (up or down) from current levels over the next year.
There is nothing magical about the VIX – it is more a reflection of what has happened than what will happen. Since the indicator’s inception, there has been an 84% correlation between the 21-day historical volatility of the S&P and the current level of the VIX, meaning that what happened over the past month can possibly explain more than 60% of why the VIX is where it is.
Knowing this, we don’t have to use the VIX at all. We can just look at historical volatility. The good thing about this is that we are now free from the bonds of limited data. We can compute historical volatility for an index for as far back as we have price data. We know that looking at historical volatility won’t give us a perfect picture of what the VIX would have looked like if it existed at the time, but it gives us a really good idea.
So let’s cure our myopia and look at 100 years of volatility:
Like the impending super-spike in oil prices (according to Goldman Sachs, anyway), there have been a couple of super-spikes in volatility, noted on the chart. But the overwhelming majority of the time, historical volatility of the Dow Jones Industrial Average stayed in a range between 5 and 30.
To calculate an “average” of what volatility has historically been, it’s best to use the median value. A median is not skewed by the “super-spikes”, and gives us a truer idea of what a typical volatility reading has been. And over the past 108 years, the median 21-day historical volatility of the DJIA is 12.5 (the red line on the chart above).
The blue line on the chart is the reading as of Friday, which was 10.1. We can see that it is lower than the median value, but it’s important to note that out of the 108 years that I looked at, there were 8,676 days that had a volatility level lower than Friday’s. Assuming 252 trading days in a year, that’s 34.4 years. Let me say that again…there have been a total of more than 34 years with a volatility level lower than our current one.
Cycles of Volatility
Something that may jump out at you from the long-term chart above is the undulating nature of volatility. Like waves on the ocean, there are crests and troughs, ups and downs, occurring in a fairly regular manner.
Let’s take a closer look at those cycles from the beginning part of this century.
During this sample, we can see that there were pretty regular cycles of high volatility followed by low volatility followed by high volatility, and so on. The average length of the cycles were about 5 years, give or take a year or two, as the markets went through periods of upheaval and relaxation.
This is important to note, because from 1998 through 2003, the stock market went through one of those periods of upheaval. The historical volatility of the DJIA during those years averaged 18.2 – far, far above what it had been historically.
This is interesting because the length of time, 5 years, is about on a par with the other periods of heightened volatility we can see in the chart above.
But since May of 2003, almost two full years, we haven’t seen even one day that showed an historical volatility greater than 20. Isn’t that an unusual sign of complacency? Well, no.
The chart below shows us why. The red arrows highlight the number of consecutive days the Dow went without seeing one day with an historical volatility greater than 20.
Once again, we see a fairly regular pattern. About once every decade, we see an extended period of low-volatility conditions. The average streak in the chart above is 1,154 days…nearly four and a half years.
So far, we’ve gone 491 days without an historical volatility reading greater than 20. But that’s less than half the number of days that we have seen during streaks that have occurred during nearly every decade over the past 100 years. After the period of extreme volatility we saw from 1998 – 2003, it would conform to historical standards if we went another two years or more before seeing a large (and sustained) jump in volatility.
So once this streak ends (by historical volatility rising above 20), will that be the signal to sell? Not according to history. 60 days after any streak ended that had lasted at least one year, the Dow was positive 9 out of 13 times with an average return of 7.4%. Six months later, it was higher 12/13 times with a return of 10.3%. For those with a longer time frame, buying the first large spike in volatility has paid off time and time again.
Conclusion
Nothing really has changed from the last comment. Many of our measures are registering, or have registered, enough of an extreme in pessimism that historically has meant the worst is over. There are a few holdouts, and they are the same ones that I have been writing about over the past couple of weeks.
The tug-of-war we’ve seen lately is likely the cause of (or due to?) these conflicting readings, and right now I have no desire to change our outlook or portfolio. We’re about 50% invested in QQQQ, and will likely add to that position if we see another leg lower which finally moves some of our holdout measures into their “proper” place. Should such a situation occur, it should serve to present one of the two or three good buying opportunities we will have all year.
All the best,
Jason Goepfert
President and CEO
Sundial Capital Research, Inc.
Disclosures of personal positions are not intended as trading advice in any form. They are 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.
© 2005 Sundial Capital Research, Inc. All Rights Reserved.