Should You Go Long at Volatility Extremes? Nikkei As Example

Japan’s Nikkei 225 stock index is the primary index used to track the Tokyo Stock Exchange. It was also the index that captured the fall of the Japanese stock market from 38,959 on the last day of 1989 to 7,603 in April 2003, a drop of 81% over the course of more than 13 years.

The Nikkei, therefore, provides an opportunity to test the idea of whether it is profitable to initiate new long positions in times of extreme volatility, even in prolonged bear markets.

In order to test this hypothesis, I reviewed the data for the Nikkei 225 from 1984 to the present and singled out the ten most volatile days during this period, using various volatility measures such as historical volatility and average true range. The result, which includes a number of overlapping days and clusters of similar volatility extremes, is displayed graphically in the chart below, courtesy of Stockcharts.com. In the chart, the seven instances with the highest volatility levels are highlighted by green arrows. Note that in each case a rally of at least two months followed these volatility extremes. In the one bull market example, the new bullish trend lasted for two years; in all the other bear market examples, the new bullish trend lasted from two months to 1 ½ years.

For the record, the action in the last two weeks in the Nikkei would make the current environment the most volatile of all instances, just as is the case for the S&P 500 at the moment.

While all bear markets are not created equally, Japan's "lost decade" does bear some resemblance to the problems in the U.S. Looking at the historical record with a global perspective, it is tempting to conclude that the current situation ripe for another volatility bounce of at least two months.

Comments

[Stone Fox C...:]

The US has already had a lost decade. Durring that time we had a stock bubble and a real estate bubble, but not at the same time like Japan. Its difficult to argue that the US has another lost decade in the stock market with valuations at historical lows.

2008 Oct 24 02:11 PM

[Muzie:]

Stone Fox Capital: Finally some common sense.

2008 Oct 24 06:45 PM

[Pretzel Logic:]

Who on earth told you we are at historic low valuations? Not even CLOSE.

Using earnings per share over the trailing 12 months, the current PE ratio for the S&P 500 index is 18:1. Only 21% of the months since 1871 have had higher PE ratios than this.

We're closer to historic high valuations than we are to historic low valuations.

2008 Oct 25 02:34 AM