Volatility Revisited
Sally Limantour
The wave of risk aversion for most global equities finally broke yesterday as
rumors of a government crackdown in China on buying stocks with borrowed money and other dubious practices took hold. In our own backyard the continued concerns of higher margin debt, sub prime mortgage loans and geopolitical concerns now conspired to create fear. Up until today markets were so complacent that financial market contagion appeared to be a thing of the past. This complacency could be seen in the extraordinary absence of volatility that has been a defining feature of financial markets.
I wrote about this on 02/07/2007 stating that I was initiating long volatility strategies.
With stocks markets down sharply and exacerbated by problems calculating the DJIA index, stocks had one of its worse days in history falling over 540 points around 3:00 pm. Not all charts were plummeting however as the VIX, the CBOE volatility index shot up like a rocket closing up 64.22%. This was an unusual spike as looking back since the VIX was first introduced in 1993 there have been only 4 days in which the VIX spiked up 30% or more. It is interesting to note that the VIX has not made a 40% move to the upside since February 2, 1994 when the Fed shocked the market with its decision to raise interest rates.
This dramatic move up in the VIX still has the index at relatively low levels. Consider past events - in March 2003 when people thought the insurance sector was about to implode the VIX traded above 30. During the summer of 2002 when the telecom sector was threatening the VIX traded above 40.So the question now is with the VIX closing at 18.31 does this mean the index is heading higher and stocks lower? Currently we are moving up from very low levels in the VIX so the percentage move up in one day is extreme. Markets revert to the mean (each way) so I would expect a short covering rally in stocks and a correction in the VIX back to lower levels in the short term. Typically VIX spikes last for a day and retrace on the second day.
Going forward, given that the market’s persistent and long running appetite for risk I expect volatility to trend higher and stocks lower in the weeks ahead. Also, my global volatility indicator that measures over a hundred global financial assets still remains at a low level and is far from signaling a buy on global stock markets. As mentioned on the post here on 2/12/07 (S&P and Currencies) my medium and long term model were warning of a “high wave risk aversion” (meaning a sell signal) and I was concerned about the unwinding of the carry trade and mentioned “we could see a bear trap rally in the yen.” All of this could lead to what was referred to in a FT article, “The Great Unwind is Coming.”
I will add that with the creative financial engineering we have witnessed leading to highly leveraged derivative strategies it is difficult to assess where real liquidity begins and leverage ends. This is something we will find out in the weeks ahead.
