Yeah, I’m talking about volatility. As I mused earlier last week, this isn’t what bottoms look like, and we’re only getting part of the way here. We’re looking at breaking 44 for the VIX, which has been a crisis indicator in the past, and we still need to top the previous peak at 50 on the VSTOXX to be fully in panic mode. But suffice to say, there are further drops to be had, and I’m happily owning emerging market gold plays at the moment. (Bloomberg link to VIX the post linked to.)
But if we accept that volatility is here, and things will get even worse, what things are there that we might need to consider in order to be reading more from what volatility tells us?
First: run a correlation check between declines and volatility, and see what it tells you. When markets fall beyond a certain point, volatility intrinsically and inversely bonds with price, and falls in market values get direct correspondence with volatility. Thus, people are seeing risks they did not calculate, and are running to the exits faster than the capacity of the stairs down. Good time to be selling wet cloth branded “fire blanket”. In normal times with big, discernible trends, there is less of a strict correlation, and price and volatility tend to be somewhat uncorrelated with volatility trading within tight bands (5 points on either of the above indices) nearly regardless of what price does.
Second: discount the future. The world markets were down like a rock in mid-march following the Tohoku earthquake, but volatility “spiked” very calmly and quickly fell back in line. Of course, that was a short-term dip and in the financial sense would play out over about 6-9 months, relatively present, and doesn’t do too bad a harm on the discounting equations in the far future that govern finance. The latest routs, on the other hand, are purely speculation on the sum of future earnings globally, and thus brings down valuations substantially. Thus, volatility now says that traders’ expectations of the far future are waay worse than they were two weeks ago.
Third, finally, and as always: check your fundamentals. Depending on your predisposition you will either have been nodding affirmatively, or been utterly confused by this statement. Those nodding and quoting all the news out yesterday – from jobs data, manufacturing indices in the US, investigations into bank liquidity and dollar assets… this is too cumbersome, you know what I’m talking about! – are very likely to have lost money. Why? None of these are new fundamental factors, and the selloff started before any of these had even hit the market! The truth is that there were no big, new fundamentals out there: all of this either someone like me could have told you about (see linked post for liquidity discussion) or is not particularly important! People sold off for no reason, they are scared that things are gonna be worse than expected in these numbers. And yet they aren’t irrational: most of the forecasts for yesterdays data were either made using data that presaged the latest market rout, or otherwise generally suffers from positive bias on the forecasters.
So, what now? Well, we still haven’t seen true liquidity dry-up. Markets just look like an amplified version of a down day, orderly falls, a little bit of consolidation/correction and occasional stabilization broken off by firm selling. But no vast minute-to-minute 2% or more gyrations. To visualize, this looks more like someone took a heartbeat monitor over five heartbeats and tilted it. Disorderly, liquidity strapped markets by contrast look more like a single heartbeat chopped off at arbitrary points, where traders are scrambing over each other trying to snap up some of those quotes that are strewn around like highway light posts rather than Christmas house decoration lights.
Since the news are unlikely to get better, and banks are tapping dollar liquidity lines for their Wall St. operations, I’d say we’ll have atleast another +30% VIX day next week taking it to around 55-60 and should correspond to a market value below 10400 for the Dow (61.8% fib between March-09 lows and post-crisis high) but likely settle before the 2010 summer Europe-induced lows at ~9600 (50% fib!). For Europe, it looks worse, and I’m not willing to call prices generally when markets are forecast to be this bad (if you can’t trade, technicals don’t matter, barely even fundamentals for that matter. The only thing that matters is getting quotes. Why we trade off technicals based on these situations after the fact is a mystery to me… well, another post) but I think the VSTOXX has to visit north of 70, or serious fundamental backstops like political change on a European level enters the equation before Europe is out of the woods.