Friday, March 2, 2007

VIX

The well-known volatility index on SP500 is called VIX and can be traded as a futures contract (not very actively, though). Just before the current spate of market weakness VIX was at ~10.00 and the April futures contract was at ~13, i.e. it was in steep contango. You may recall that I have been following volatility for a while now (see post of Feb. 5).

Today, after the recent huge volatility, VIX is at 18.50 and....the futures contract is at 15.50 (!!), having gone into steep backwardation. What is going on?

Unless there is something else going on that I do not understand (very possible), the "market" seems to be saying this is just a hiccup, nothing to worry about, so go back to sleep.

Hmmmm...if anyone has any input into this, kindly leave a comment. Thanks in advance.

3 comments:

John J. Xenakis said...

Although the official VIX is computed via a complicated formula, I think of high volatility intuitively as meaning that the stock market as a whole is making wild swings up and down. This occurred earlier this week, on Tuesday, when the market swung through a range of over 500 points. By Friday, the volatility had gone down, and Friday was a fairly quiet day.

In "normal times," investors make buy/sell decisions by examining individual stocks. When investors take individual paths, betting on individual stocks, then one investor's gains are canceled out by another investor's losses, so the market as a whole remains steady, and volatility is very low.

But when volatility spikes up, it means that investors are now betting on the market as a whole, rather than on individual stocks. It's a state of frantic, high anxiety, because investors are panicking, for fear that the entire market will fall further, and they'll lose money, or that the entire market will go upward, and they'll lose the opportunity to make money.

When investors get into this state, they're essentially treating the entire market as a single stock, and they either buy the market or sell the market.

Now, the point is that, even in normal times, an individual stock is much more volatile than the market as a whole. A scandal could force an individual stock to fall 50%, or an unexpected merger rumor could double the stock value.

When investors are so frantic that they treat the entire market as a single stock, then the stock market as a whole can become extremely volatile, subject to any bit of news or commentary. That's when the volatility is high.

So it becomes a cycle. Bad news makes the investors anxious. Anxious investors sell off, and the selloff becomes more bad news that makes investors even more anxious. Under the right conditions, the anxiety reaches a tipping point and turns into full-scale panic.

Those are very dangerous times. Just as an individual stock could fall 25% in a day or two, when investors treat the whole stock market as if it were an individual stock, then the whole stock market could fall 25% in a day or two, as happened in 1929 and 1987.

So why did volatility fall on Friday? Does that meant that the entire episode is over?

It's not that investors suddenly became any less frantic or panicky; it's that they thought the immediate danger was over. There was going to be no "magic signal" on Friday.

Investors are on a knife edge, waiting for some kind of "magic signal," telling them to sell before everyone else does.

They suspect that something very harsh is coming, and they're trapped in a high-stakes game: If they get out right away, then they might miss the next bubble high; if they miss the "magic signal," then they'll get caught in the "correction."

I believe that few investors suspect the 50-75% stock market crash that is coming; they're debating whether it will be 7%, 10% or, worst case, 20%.

Now, here's an additional piece of insight that I found absolutely fascinating: According to CNBC, the "big money" on Friday was very disappointed because the market didn't fall further, and because there was no "smell of panic."

Why? Because they've got it all figured out. They have the formula down pat. At the first sign of volatility, the "big money" gets out. When there's "enough" volatility, a "smell of panic," then they get back in. It's a simple formula and it always works. Until it doesn't.

And why wouldn't it work? Because they're using outdated macroeconomic models. Why are they outdated? Because they were developed or updated during the housing bubble. Why would a macroeconomic model developed during a massive housing bubble provide accurate information about a time when there's a massive subprime credit meltdown?

Have you ever watched TV when there was a hurricane headed for the southeastern coast of the U.S.? They have a guy from the NOAA come on, and he typically explains how they use three different computer models: one model predicts that the hurricane will make landfall in Virginia, another predicts Florida, and another predicts Louisiana. Those computer models were developed by modeling hundreds of hurricanes over a few decades, and even so, the model isn't very good.

But you can't do that with macroeconomic models because all the assumptions are constantly changing. Today's environment, with the subprime meltdown, bears no similarity to the environment five years ago, when credit was loosening and the bubble was exploding.

This is the point I was making in my article on System Dynamics and Macroeconomics that I wrote last October: That mainstream macroeconomics has completely failed to predict or explain anything since the beginning of the 1990s bubble. Economists have literally gotten just about everything completely wrong. They don't have the VAGUEST IDEA what's going.

So when you read Richard Berner's Friday column, where he discusses different macroeconomic models, you quickly realize what nonsense mainstream macroeconomics is. Look at this paragraph:

How do we calibrate that financial stimulus? Some compile a financial conditions index as a weighted composite of changes in asset prices. We prefer a combination of models assessing interest rate, currency and wealth effects, and judgment. Financial conditions indexes do help us cross check our judgment and models; for example, a model-based index from Macroeconomic Advisers was still in positive territory at the end of 2006. But even such sophisticated indexes may understate the financial prop to growth, because they miss the contribution from tighter lower-rated credit spreads and credit availability.

This paragraph is so idiotic, I almost decided to write an article for my web site naming Richard Berner "This week's idiot of the week." The whole point of using a computerized model is because there are thousands of variables, too many for an individual to grasp. But apparently those computerized models -- the "financial conditions index" or "the Macroeconomic Advisers index" -- aren't good enough for Berner. He'd like to use wealth effects and other variables, including "judgment." Judgment? Where does he claim to have developed this judgment? During the 1990s stock market bubble? During the 2000s housing bubble? He's completely full of crap.

And now get this for the real kick in the ass: Bloomberg has just published an article saying that Morgan Stanley, Goldman Sachs and Merrill Lynch have just had their bond ratings lowered to Baa2 -- almost "junk" status. Why? Because these investment firms had invested in mortgage banks that have now gone bankrupt.

Well, if these guys are so stupid that they drive themselves into junk status, then what reason do we have to believe that they're any less stupid now?

If these guys define their "Macroeconomics" models, then I'd like to define the Xenakis "Macroeconomist" Model. Go back and determine the results of each economist's predictions, and use those results to estimate how much of a moron he is.

These people are all Boomers, and like people in the Boomer generation generally, they're completely lost. They've developed simple rules that always work: Get out on volatility, get back in after the smell of panic. It's a simple rule. They don't have the vaguest idea why it's worked in the past; in fact they don't have any idea what's going on at all. They just apply the simple rules, and figure that they'll always work because they're Boomers. And if they don't work, it's not their fault anyway, because they're Boomers.

But underneath that top layer of simple rule-playing and computerized models, there's a real air of desperation out there. Nobody knows what's going on or what to expect next. Hell, I haven't heard anyone else mention this, but I thought that when Bernanke testified this week, he looked to me like a scared rat on a sinking ship. He was very professorial, but his facial expressions clearly showed fear.

I can just imagine Richard Berner there, sitting at his computer, typing that idiotic column. "Let's see, do I like interest rates today or do I like wealth effects? Which one makes the results come out they I want them. Wealth effects? OK, let's go with that." As we like to say, garbage in, garbage out.

Sooooooooooo, I've rambled on a bit, without finishing my answer to your original question. Here's the answer:

Volatility can turn on and turn off in the blink of an eye. Nothing really changed on Friday except that everyone figured they were safe for the weekend and turned volatility off. It will take only one sour note to turn it back on again, and there's no way to predict how harsh the results will be next time.

---

By the way, I have a question for you. I've just posted an article on my web site on "Where should I put my money," answering questions about things like buying gold, short selling, currencies, and so forth. Could you read it and tell me if you think any of it is wrong? I'd hate to mislead anyone.

I have another question. If you've seen my web site then you know that I'm pretty contemptuous of the so-called experts who are letting this financial disaster happen, right before our eyes, and I believe that many of them will be sued for or charged with fraud if it turns out that they protected themselves by selling when they told everyone else to "buy" in order to make a commission. In a sense they're just trapped, because any one of them that predicted a stock market crash would lose all his clients and/or be fired. My question for you is this: If you published your real name on this blog, would you lose all your clients and/or be fired?

Sincerely,

John

John J. Xenakis
E-mail: john@GenerationalDynamics.com
Web site: http://www.GenerationalDynamics.com

Hellasious said...

Dear John,

Thanks for your long comment, touching on several subjects.

First the "technical" part:

VIX did not fall on Friday; it rose sharply and closed at the highest level since June. It was the FUTURES contracts on VIX (traded on CBOE) that exhibited the weird behavior I referred to in my posting, going from contango to backwardation. I take this to mean that whoever is active in this VIX FUTURES market views this whole episode as a hiccup that will soon pass. VIX right now is 18.61 and its March futures contract is around 15. I think they are wrong, but we shall see.

Volatility, as calculated by VIX, is not the same as a statistician would understand it. For example: if the market were to drop 200 points in the morning and rise 500 point immediately thereafter VIX would go down, not up. VIX is essentially an index that follows the value of put options only, not a mathematical construct based on the statistical definition of volatility.

On the subject of why professionals say what they say, your blog sums it up well.

The investment banking business is based on fees and prop trading. Every house has a different mix, but customer business is always essential, even for prop trading, because it provides knowledge of customer order flows. It is mostly a win-win business.

The only thing that kills it is a serious drop in transaction volumes. Since bear markets always generate much less volume, not many "professionals" will predict one. So, they are congenital perma-bulls not because they are stupid but because that's their business and you can't expect them to advise you to abstain.

What should people invest in, if what you expect is to happen?

1. Get out of debt NOW. This is an "investment" that always yields much more than anything else, consistently.

2. If you have a mortgage send in extra payments every month with a note they should be applied against the PRINCIPAL.

3. Recognize that consumption is not a substitute for a fulfilling life.

4. If you still have money left over every month stick it into T-bills, for now.

As for publishing my name on my blog: Discretion is 9/10ths of friendship, particularly when it comes to slaying other peoples' sacred cows. I have lots of friends in the finance business that I respect, even though I may not agree with them. At the moment I find myself disagreeing with too many, from the negative side, so no reason to offend and burn bridges in a public forum. Cassandra was right, but she didn't make any friends.

When the time comes to disagree from the positive side I may well do it publicly.

Regards

John J. Xenakis said...

> First the "technical" part:

> VIX did not fall on Friday; it rose
> sharply and closed at the highest level
> since June. It was the FUTURES contracts
> on VIX (traded on CBOE) that exhibited
> the weird behavior I referred to in my
> posting, going from contango to
> backwardation. I take this to mean that
> whoever is active in this VIX FUTURES
> market views this whole episode as a
> hiccup that will soon pass. VIX right
> now is 18.61 and its March futures
> contract is around 15. I think they are
> wrong, but we shall see.

> Volatility, as calculated by VIX, is not
> the same as a statistician would
> understand it. For example: if the
> market were to drop 200 points in the
> morning and rise 500 point immediately
> thereafter VIX would go down, not up.
> VIX is essentially an index that
> follows the value of put options only,
> not a mathematical construct based on
> the statistical definition of
> volatility.

Thanks for the technical correction. I appreciate it.

But I was in fact responding to what I thought you were really asking -- what was different about the "atmospherics" on Friday that might have led investors to think that the selloff was only a "hiccup," and I tried to answer that.

The atmospherics were very different on Friday -- much different than on the preceding three days. Earlier, the discussion was whether the market was having a complete meltdown. By Friday, the only discussion was whether the selloff would be 7%, 10%, and 20%. Furthermore, the rest of the discussion was over whether the market would be reaching new highs again in two weeks, two months, or six months. Before Friday, no one had any idea what was going to happen; by Friday, there was no longer any doubt that things would quickly return to "normal."

> The investment banking business is based
> on fees and prop trading. Every house
> has a different mix, but customer
> business is always essential, even for
> prop trading, because it provides
> knowledge of customer order flows. It is
> mostly a win-win business.

> The only thing that kills it is a
> serious drop in transaction volumes.
> Since bear markets always generate much
> less volume, not many "professionals"
> will predict one. So, they are
> congenital perma-bulls not because they
> are stupid but because that's their
> business and you can't expect them to
> advise you to abstain.

Sorry, I'm not nearly that kind and, fortunately or unfortunately, I have no friends in high places whose feelings might be hurt.

Most of these people have a fiduciary responsibility to their clients. That means that if they think the market is going down, they have a fiduciary responsibility to say so. Professionally, they don't have the "right" to make up macroeconomic models that bring in the greatest levels of income. I call them stupid because I hold them to a much higher standard than I hold an ordinary person. They're supposed to be experts. So either they don't know what they're talking about, which makes them stupid, or they know what they're doing and thereby risking going to jail, which also makes them stupid.

I can assure you that history shows that when this is all over, my assessment will be much more widely held than yours.

> 1. Get out of debt NOW. This is an
> "investment" that always yields much
> more than anything else, consistently.

Thanks for mentioning this. I should have included something like this, and I'll add it.

> Cassandra was right, but she didn't make
> any friends.

That's for sure. Being right over and over has never brought me anything but grief. As you say, being right didn't help the legendary Cassandra -- she was reviled and raped for her trouble. I guess I'm lucky since no one has yet "raped" or assaulted me, but the worst may be yet to come.

Sincerely,

John

John J. Xenakis
E-mail: john@GenerationalDynamics.com
Web site: http://www.GenerationalDynamics.com