 SPX Volatility
Extinctions 2
Adam Hamilton
Archives
June 26, 2004
From a speculator's perspective,
2004 has been one heck of a dull year so far in the US stock
markets. The very volatility that usually creates the great opportunities
to trade has been glaringly conspicuous in its absence.
Using the flagship American
S&P 500 stock index as a proxy for the markets as a whole,
the raw numbers tell this whole flatlined story. As 2004 dawned,
the SPX closed at 1108. By early February it rallied to reach
its latest interim high approaching 1158. Then it decayed and
faded into mid-May when its lowest year-to-date close of 1084
was witnessed. This tight range of 74 points yields a minuscule
trading range under 7% so far this year, amazingly low!
Just how amazingly low is this?
Well, in closing terms the SPX swung 34% in 2003 and 34% as well
in 2002. Thus, at this point in 2004 the S&P 500 has only
run through 1/5th of the range witnessed in recent years! With
the stock markets languishing in these surreal doldrums sans
volatility, both the interest in trading and volume are vaporizing
as speculators seek tradable markets elsewhere.
The art of speculation demands
buying low and selling high, and when the markets stagnate they
fail to provide the crucial low points at which to buy and high
points at which to sell. The longer an episode of waning volatility
persists, the more the general trading interest in a particular
market fades. If you are not granted interim opportunities to
either buy low or sell high at least a couple times a year or
so, there is little point in spending time and effort to follow
a dull market.
I have been marveling at this
abnormally low volatility in the US equity markets all year.
This week I would like to analyze and quantify this strange phenomenon.
Is our perception of unnaturally placid markets backed up by
the actual raw volatility data?
In order to execute this research,
we decided to look at interday volatility, the actual day-to-day
change in the closing price of the S&P 500. Unlike the mathematically
complex implied volatility indices like the VIX, simple interday
volatility is a much cleaner number since it does not rely on
continually shifting options expectations running one month into
the future. True volatility and implied volatility are both very
useful and have their places, but this week we are using the
true absolute interday numbers.
Provocatively though, the S&P
500 VIX and S&P 100 VXO implied volatility indices have just
this week carved their lowest closing lows since the Great Bull
of the 1990s. The NASDAQ 100 variant, the VXN, has plunged to
all-time record lows. So while we are not specifically looking
at the implied volatility indices this week, they also provide
rock-solid evidence that 2004's abnormally low volatility is
very real and not just in our heads. Truly something strange
is afoot.
I last discussed absolute volatility
in October's "SPX
Volatility Extinctions" essay if you would like more
foundational background information on these studies and their
implications for speculators. Our graphs this week are modified
updates of those earlier ones, focusing exclusively on interday
volatility this time around.
Absolute interday volatility
is calculated by subtracting yesterday's SPX close from today's
and dividing the difference by yesterday's close. An absolute
value is applied to this quotient to ensure all the resulting
volatility numbers are positive and comparable. The dark gray
lines below graph these raw numbers, which can fluctuate quite
violently day-to-day. A 10-day moving average, drawn in red,
is also applied to smooth the raw absolute interday volatility
calculations.
Our first chart takes the long
strategic perspective, examining interday volatility in both
Great Bull and Great Bear markets since the late 1990s. It is
provocative to note that not even when the S&P 500 doubled
from 1997 to 2000 did we witness a similar period of extraordinarily
low volatility as we have seen thus far in 2004. The hard data
backs up speculators' perceptions of something weird transpiring
today.
If you concentrate on the red
absolute interday volatility 10dma line in 2004, it is apparent
it has hovered around 0.5%. On average, so far this year the
day-to-day changes in the US stock markets have averaged a trivial
and not very exciting half percent or so! On a sidenote, when
my partners and I talk about the markets each day as we work,
we consider any daily move in any market of less than 1% or so
to be "unchanged", not even worthy of consideration
in isolation. Most of 2004 has slumped under this key metric.
Yawn.
In fact, if we average the
interday volatility for the first half of this year, we arrive
at an average daily move of only 0.58% for the S&P 500. This
number, along with the annual average interday volatility numbers
for all of the years shown in this graph, is noted above in yellow.
We'll delve further into these yearly averages below, but for
now just realize that 2004's unnatural serenity has been far
more pronounced than even during the Great Bull years of the
late 1990s.
Why is volatility so important
to consider? As I outlined in my original essay, it is one of
the best proxies for general greed and fear in the marketplace
as a whole and hence tends to mark major interims tops and bottoms
remarkably well. There is no more powerful force driving short-term
market movements than this general greed and fear among speculators
as a group.
If you carefully examine every
major SPX interim low in this graph, during both bull and bear,
you will note that they all corresponded with big spikes in interday
volatility. Conversely, major interim tops coincided with periods
of low volatility. If some visual guides would make this easier
to see, the first graph in "SPX
Volatility Extinctions" has vertical lines drawn in
to connect these volatility episodes with the respective interim
turning points which they flagged in the S&P 500.
Volatility quantifies general
speculator emotions so well because it captures the behavior
of traders at turning points, and this behavior is driven by
emotions. The greed and fear that drive the short-term markets
are asymmetrical, with fear being a much more powerful and urgent
emotion than greed. While greed nurtures itself gradually, fear
ramps up very fast once speculators feel they are in danger of
getting really hurt and losing big.
To illustrate this market truism,
imagine the behavior of a group of tourists visiting one of those
enormous Las Vegas casinos on the Strip. As the tourists wander
through the casino floor, they see other people winning money
so they get interested. After observing a bit they are sucked
into the glitz and glamour and are ready to gamble. They sit
down, relax, play the games, and visions of wealth dance through
their heads. Speculators in the financial markets act the same
way, biding their time initially and only growing greedy once
they see someone else winning so they want a piece of the action
for themselves.
On the other hand, what if
this same group of tourists was in the casino when a cell of
terrorists armed with AK-47s and grenades burst through the doors
and started randomly shooting people. God forbid, but the black
fear would be overwhelming and everyone would instantly forget
gambling and jump up and scramble for the opposite doors, creating
a stampede. Once people fear for survival, their own or their
capital's, fear wells up instantly and the need to escape becomes
blinding and all-consuming. In the financial markets this flaring
fear coincides with the heavy selling at major interim lows.
In the stock markets volatility
acts as a proxy that quantifies general greed and fear. When
the markets are up and others are winning like at the casino,
greed waxes extreme among speculators. Trading tends to be less
aggressive as everyone relaxes and enjoys the ride. Without heavy
trading, volatility gradually shrinks towards oblivion as greed
rules. Naturally though, as all contrarians know once greed grows
too great an interim top will be reached and a correction or
downleg will be necessary to burn off the greedy speculative
excesses.
Once these corrections or downlegs
run their courses, general sentiment is overwhelmingly negative
as a major interim bottom is approached. As fear soars, speculators
grow frightened and run for their lives much like the tourists
would during a terrorist attack at a casino. Heavy panic selling
leads to a great increase in volume and an explosion in volatility.
And just when things seem like they are never going to get any
better again, the capitulation ends, volatility plunges, and
the next rally or upleg can rise like a phoenix from a clean
sentiment slate.
This pattern is fascinating
as it holds up flawlessly in both bull and bear markets. Emotions
are powerful forces, but they only react over the short term.
Thus, an endless torrent of tactical emotional waves running
from greed to fear and back again cascades through the markets
constantly, regardless of whether the primary long-term trend
is bullish or bearish. The chart above really drives home these
crucial speculation concepts.
Therefore from a contrarian
perspective the prudent course of action when popular greed swells
and general volatility nears extinction is to sell and plan for
an approaching correction or downleg. Bringing this analysis
full circle, right now in 2004 we have seen the lowest volatility
levels in about a decade or so. Low volatility always betrays
extreme greed, an environment much like today's when the vast
majority of players expect the markets to catapult higher. Yet,
these very greed/volatility extremes tend to mark major interim
tops, the time to sell or go short.
While the nearly year-long
unnaturally low volatility stretch through which we are sojourning
today is certainly unequalled anywhere else on this chart, it
is really provocative to note the only other place which came
close. If you examine the 0.5% line relative to the red 10dma
above, you will note that the only remotely comparable volatility
period was the notorious summer of 1998.
The summer of 1998 was initially
much like today, with very positive general sentiment and a complete
lack of fear coupled with the usual vacation-months slowdown
in trading. The past year had been very kind to stock-market
investors and Wall Street predicted great gains ahead. All it
took was an unforeseen exogenous event, however, to shatter this
bubble of complacency and pummel the SPX 19% lower in a matter
of weeks.
Devaluing currencies and a
Russian default on its sovereign debt led to enormous problems
for hyper-leveraged derivatives players like the elite hedge
fund Long-Term Capital Management. LTCM's spectacular implosion,
of course, frightened Wall Street and the Fed so badly that they
engineered a bailout lest the derivatives fireworks spread and
endanger the entire US financial system. While the low volatility
in stocks did not spark this crisis, it did provide the perfect
backdrop of complacency and low volume to greatly magnify its
impact on the markets.
The past year or so has been
even worse in terms of greed and complacency than the summer
of 1998! For a lot of reasons including the upcoming US elections,
speculators just seem to generally believe that the stock markets
can only move higher. However, as contrarian speculation theory
states, the very times when consensus is vastly in favor of one
particular direction is when a sharp move in the opposing direction
becomes most probable.
A topping market on low volatility
is very fragile and highly susceptible to a catalytic shock from
some unforeseen exogenous event. We are certainly in this fragile
zone now, and while no one can know what potential surprises
are approaching over the horizon to spark the fear that will
pop this sentiment bubble, we can know that the risks are extraordinarily
high. In both bull and bear alike, very low volatility levels
are harbingers of a coming major correction or downleg, not higher
markets ahead.
If we zoom into this chart
to just encompass the market action since the beginning of 2003,
the amazing volatility lows and decaying topping pattern in the
S&P 500 become even more apparent. The yellow numbers on
the left show the average daily interday volatility of each of
the past seven years in reference to 2004 year-to-date. It is
certainly ominous to realize that 2004's average volatility is
running far below that of even the greatest bull years in memory,
the late 1990s.
The Great Bear years of 2000,
2001, and 2002 witnessed average absolute interday volatility
of 1.12% in the S&P 500. As expected since greed and fear
are asymmetrical emotions, the Great Bull years of 1997, 1998,
and 1999 had a lower average interday volatility of 0.89%. 2003,
not a secular Great Bull but a definite cyclical
bull, weighed in at a very similar 0.83% in volatility. All
of these numbers make sense in light of the way volatility works,
until 2004 enters the scene.
Year-to-date, we are only running
0.58% in average absolute interday volatility in the SPX. This
number is stupendously low and arguably flags one of the most
overly complacent markets in modern history. With 2004 volatility
only running about 2/3rd of what we would expect during a typical
bull market, the probabilities of this being a major interim
top grow very high.
The technical picture certainly
supports these topping arguments as well. In S&P 500 terms,
the blue line shows the decaying downtrend channel in the SPX
in 2004. The US stock markets are gradually making marginally
lower highs and marginally lower lows. Meanwhile the 50dma and
the 200dma of the SPX are converging. The next minor selloff
in the S&P 500 could very well take it below its key 200dma
bull-market support just under 1100 now.
And while the S&P 500 appears
to be topping, volatility is flatlined along that incredibly
rare 0.5% interday 10dma line. While 0.5% has been touched about
a dozen times in the last decade or so, it is extremely odd to
see volatility remain near or under it for almost a year straight.
The red technical lines framing the volatility 10dma trend really
highlight this flatlined hyper-complacent development.
Another interesting observation
involves the actual raw interday volatility data itself, drawn
in gray above. In 2004, the highest absolute volatility days
have only run around 1.5% or so. This compares to high days of
3% to 4%+ in normal bull and bear markets. Even on the most "extreme"
days so far this year, the extinction of volatility becomes apparent
and really sticks out like a sore thumb.
Why is volatility so low? I
suspect it is probably at least partially because of the powerful
election-year propaganda that Wall Street has been so zealously
advancing this year. All day long we hear on CNBC and read in
the financial newspapers how election years are generally positive
for stocks. Never mind the last election year of 2000, which
finished down by the way. After enough repetition of this election-year-bullish
mantra, true or not, bulls get lulled into complacency so they
don't trade and bears just stand back so they don't get hurt.
A lot of folks believe active
manipulation is happening in the SPX futures to attempt to steer
the US markets in a tight trading range at worst leading into
this autumn's elections. The usual suspects are believed to be
responsible, the Fed and/or the Working Group on Financial Markets
(aka Plunge Protection Team the Wall Street Journal talked about
following the 1998 crises). Not being an SPX futures floor trader
myself, unfortunately I can't know for sure either way on this,
but I do know without a doubt that for unknown reasons 2004 has
been unnaturally calm.
Whether these surreal volatility
doldrums are a consequence of herd psychology or active engineering,
the longer they last the higher the probability of a serious
correction or downleg becomes. Sentiment in the financial markets
is like a great pendulum, the farther it swings towards greed
the more momentum it gathers so the farther it will careen back
into fear once it reverses. Like a rubber band can only be stretched
so far before breaking, there are finite limits to popular greed
and complacency.
Disregarding the disturbing
volatility extinctions today, the headline markets appear to
be relatively strong with little risk involved. I suspect this
is what most American investors feel today, high complacency
and little fear that prices are going to fall leading into an
election. But when volatility and other sentiment indicators
are considered, complacency and greed are far too high. These
are the exact market weather conditions we would expect before
a major fall.
In general, in bull and bear
alike, low volatility is a telltale sign of major interim tops,
not bottoms. Just when greed and complacency wax the most extreme,
the markets tend to correct or fall to bleed off these unhealthy
speculative excesses.
Just as many speculators have
sensed, the raw numbers absolutely back the observation that
volatility levels in 2004 have been off-the-map low. These strange
developments are no doubt important and should not be taken lightly.
With today's anomalously low
volatility, it sure appears like probabilities massively favor
the thesis that we are witnessing a major interim top in 2004.
If low volatility marks major interim tops, then isn't it logical
to assume that unnaturally low volatility marks even bigger major
interim tops as well?
I don't know what the catalyst
will be that pops this massive bubble of complacency boiling
in the US stock markets today, but it is probably stealthily
approaching over the horizon. Please be careful on the long side
until we see how this peculiar anomaly manages to resolve itself.
June 25, 2004
Adam Hamilton, CPA
email:
zelotes@zealllc.com
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