Through The Fly's Eyes: Volatility

from Theflyonthewall.com

A Technical View

This is a follow-up to the sentiment piece we posted last week. At that time we mentioned that there were several measures of investor sentiment that need to be monitored on a regular basis to give investors a better sense of where the market is in terms of cycles (whether bearish or bullish).

Today we will look at volatility, in terms of the industry benchmark of the CBOE Volatility Index (VIX), which measures the volatility of the S&P 500 stocks.

Volatility is actually a very complex topic, which we will simplify greatly here. In essence, the index measures the level of fear or complacency in the market. What do we mean by that? When the volatility measures are historically low, which we can see in the chart are near record lows, investors are not concerned with price fluctuations or direction (note that we have inverted the VIX scale to match price fluctuations more easily in the S&P 500 in the lower panel). In simple terms they are relatively complacent about the future direction and severity of price swings along the way. In this environment investors believe that bullish trends are likely to persist.

By contrast when measures are high (above 25) there is a great deal of concern about the severity of price swings and the overall direction of those swings. As we can see on the chart there have been relatively few times where volatility has reached the 25 area, let alone broken above it. At the high extremes we can see lows in prices form.

However when the numbers stay persistently high or are in the process of rising (fear is increasing) price tends to drop as well during that time and reverse only when the direction of volatility changes. So the directional change, or trend, of volatility must be monitored along with levels.

We also have to take note of the relative volatility within any given time frame. What do we mean by this? We can see that from the time of the Russian default in 1998 through to the lows in 2002/2003 that there were nearly unprecedented levels of volatility for a very long period of time. Price swings were very large in both directions as volatility oscillated between 16 at the lows of volatility (price highs) to 40 and above at the volatility highs (price lows). Even though 16 in a broad context is actually quite high for the VIX, during that period it was the low.

In the period since the market lows in 2003 volatility has "collapsed" to around10 being the rough low bar (which we saw in the prior week) to 19/20 being the high bar (as we saw in the recent July/August low as indicated on the chart). We can see prices took off from that VIX high in very dramatic fashion as the VIX shrank back toward the 10 area. You can also see that the high and low oscillations in the S&P 500 roughly correspond to the oscillation from low to high and high to low in the VIX.

Where does this leave us? We can see that volatility is just beginning to rise slightly after hitting the low in late November. This is not surprising given that there have been some high level upsets in names (Pfizer today for example) which will tend to make investors anxious about prices and the future of price swings not only in the given name, but entire sectors. It would not be surprising to see volatility increase at this time. It also does not mean that prices will consistently fall in higher volatility. Part of the reason being that some stocks may experience dramatic price appreciation while the majority of stocks fall (thus volatility as a whole increases) as we saw in 1999-2000. If the names are heavily weighted in the index, the index can still rise. Increases in volatility can also be indications of additional options activity (increase in demand for puts) as a means of preventing (hedging) possible losses. Sometimes there is no price drop as anticipated, volatility will return to the low end of the scale in those cases without the stock index necessarily doing anything at all.
What will happen is that the premiums paid for calls and puts will swing wildly, without stock prices necessarily following.

So what use is the VIX then? Our method is to look across at multiple sentiment indicators to get the best sense we can about where the intentions and committed dollars of investors lie or will lie. We have seen that bullish sentiment is high in our previous piece, we have seen that the VIX measure is very low today. We can say that so far that these different sentiment indicators are confirming a high level of bullishness. That is cause for caution. In our next piece we will look at put/call and call/put indicators to see if this third sentiment indicator confirms the other two or shows a divergence.

Charts created with Equis MetaStock