Volatility Watch: Waning Over the Next Few Months

The science art of forecasting volatility more than a couple of weeks out has always struck me as a lot more like astrology than astronomy, so it was with some mild apprehension that I thought I should update my VIX macro cycle chart here and see what previous posts in this area predicted for 2008.

The good news is that in December 2007, in Was 2007 the Beginning of a New Era in Volatility?, I managed at least to nail the persistence of the recent trend by noting, “the current rise in volatility should persist through all of 2008, even if the rate of rise in volatility begins to slow.”

In what looked like a much safer prediction, I said, “the rate of change in volatility over the course of 2007 is unsustainable going forward – or at least inconsistent with the slope of volatility macro cycles during previous cycles.” As the monthly chart below shows (click to enlarge), the VIX essentially moved sideways to down from July 2007 through August 2008, at which point the recent volatility began in earnest.

My most recent VIX macro cycle update comes from March 19, 2008, just three days after Bear Stearns was sold to JP Morgan (JPM). At that point in time many believed volatility seemed to understate the gravity of the financial turmoil. For historical context, I will repeat my assessment at the time:

I still anticipate that volatility will spend a good portion of 2008 in the neighborhood of 22-26. Looking at the current VIX futures quotes, where the May through December futures are all trading just below 26, it looks as if my prediction is on the low end of the market consensus.

The big question I have is about the duration of current VIX macro cycle – and of course the slope of any continued increase in volatility. If the current slope of the volatility increase holds and the minimum cycle time is two years, that would project to a sustained VIX of about 40 by the end of the year. I don’t expect to see that scenario unfold, but it will be interesting to see how long it takes for the runup in volatility that started about 15 months ago to run out of steam.

So…7 ½ months later I can say that my prediction held up through mid-September, but once Lehman Brothers (LEH) filed for bankruptcy, the LEHVIX and VIX went through the roof and my predictions went out the window.

From a macro cycle perspective the two questions to ask now are how long the current cycle of increasing volatility should last and what direction the next cycle will take. Using the historical norms of a 2-4 year cycle and considering the steep trajectory of the recent 22 months of increasing volatility, I suspect that the current cycle is nearing an end and either topped out at the beginning of the week or will see one final topping move in the next month or two.

The direction of the next move is the bigger question and the more difficult one to answer. Two of the three previous changes in volatility have ended in a multi-year sideways move. Given some of the structural and fundamental challenges currently facing the economy, the easier prediction to make seems to be several years of elevated volatility.

I am going to go out on a limb, however, and stick to my fear bubble thesis to predict that volatility will be on the wane over the course of the next two years or so. Don’t succumb to anchoring when it comes to a VIX of 70. Just two months ago the VIX was in the teens. While it may be a while before the VIX returns to the teens, I would be very surprised if the VIX were not back in the 20s in another 2-3 months.

Of course, a large part of the path forward will be strongly influenced by the policies and regulations put into place by governments that have yet to take office – all of which substantially increase uncertainty around any prediction.

(chart courtesy of StockCharts.com)

Comments

[TarCottage:]

Today with financial institutions controlling 75% of shares and individuals only owning 25% (verses 94% in 1950), may also explain some of the recent market volatility. Throw in margin calls and redemptions and you get a rather explosive mixture.

2008 Oct 31 09:32 AM

[Rumpole:]

The prediction makes some sense to me, but I'm a relative newby. It just doesn't seem credible to believe that an 80+ VIX reading is sustainable. Then again, like the adage that says that markets can remain irrational longer than I as an investor can remain solvent, I imagine VIX readings can remain elevated longer than we may think despite historical comparisons.

2008 Oct 31 09:18 PM

[derryl:]

The Oct.20 issue of Time Magazine quoted Princeton psychologist Hadley Cantril's explanation of panics: "panics occur when large groups can't discern reliable sources of advice from unreliable ones".

Anyone who has been reading newspapers or blogs knows "advice" has been all over the map, from buying guns and chickens and stashing gold to buying cheap stocks with borrowed money.

Until some general understanding emerges of what the h___ is going on here, uncertainty and the resultant volatility will remain high.

2008 Nov 01 10:13 AM

[vovay45:]

Forget that moving average envelops .
MA Should be 1.
Try this simple system:
Buy next day at Limit today's Low-10%
SellShort next day at Limit today's High+10%
InstallTime Based Exit(5);
InstallProfitTarget( 5% );

Current system:EPA_V
Symbols list VIX
Position Sizing
Initial capital 100000
Maximum Open Positions 2
Position size 50% of equity
From date 01/09/2008
To date Now

Statistic

Range 2008-Jan-09 - 2008-Nov-12
Overall performance
Total % gain/loss 127.93 %
Total gain/loss 127928.81
Annualized pct gain 165.47 %
Starting capital 100000.00
Ending capital 227928.81
Closed pos gain/loss 127928.81
Max gain per pos 15948.53
Max loss per pos -10134.60
Average gain/loss per pos 4568.89
Average % gain/loss per pos 6.12 %
Max % gain per pos 20.52 %
Max % loss per pos -12.69 %
Risk etc...
Exposure 11.95 %
Expectancy 4568.89
Ulcer index 3.14
Drawdown
Max drawdown -17441.52
Max drawdown % -11.73 %
2008-May-15
All Trades
Total Trades 28
Closed trades 28
Open trades 0
Winning Trades
Winning closed trades 26
Winning open trades 0
% winning closed trades 92.86 %
% winning open trades 0.00 %
Average gain per winning pos 5608.66
Losing Trades
Losing closed trades 2
Losing open trades 0
% losing closed trades 7.14 %
% losing open trades 0.00 %

www.tradery.com/runfix...

2008 Nov 12 11:15 PM