Lessons from the Volatility Shock of 2008 12 comments
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One of the notable features of 2008 was the ‘volatility shock’—the massive and rapid rise in market volatility. It is also notable that the high probability of a volatility shock was clearly signaled by the options markets and by a range of experts well ahead of time. Volatility had been running way below the long-term average for equities as well as being at about half of the long-term implied volatility on equities for several years. I wrote about this issue quite a bit in 2007 and I was struck by the fact that the risk of a volatility shock was not discussed more until it happened. VIX, which measures implied volatility on S&P 500 options near expiration, skyrocketed to historical highs in 2008. Volatility on all asset classes tends to be correlated, and we saw massive rises in volatility on essentially all asset classes. The coupling in volatility across asset classes was another concept that got little attention leading up to 2008, but it is a consistent feature of financial markets.
Increases in volatility are costly to investors not just because they increase the “bumpiness” of returns, but because there is a negative correlation between returns on many asset classes and VIX. When VIX goes up, returns tend to go down (see this article). I documented this effect in August of 2007 and the statistics were striking. The returns on the S&P 500 and the returns on VIX (percentage changes in VIX) were correlated at -67%. The returns on EFA and EEM were correlated to VIX at -43% and -52% respectively. These are high negative correlations and show the danger signal of a rise in VIX. Further, these high negative correlations are seen in a wide range of asset classes. The negative correlation between VIX and returns reflect increasing investor risk aversion. There is also a strong positive correlation between corporate default risk and implied volatility—something I wrote about in early 2008—so the potential for a substantial rise in volatility also leads to the potential for a big increase in corporate defaults, as we have now seen.
In my article from August of 2007, I suggested that an effective way to deal with the risk of a volatility shock would be to create a portfolio out of individual stocks that had fairly small correlations to VIX and I provided a list of these stocks (see this article). The stocks proposed were the following:
click to enlarge
While the returns on most of these stocks exhibited a negative correlation to VIX, these correlations were far smaller in magnitude than we observed for the major market indexes and for a range of sector indexes. Further, these stocks all exhibited low Beta and low R-squared, which means that the returns on these stocks were not well correlated to the broader market.
We now have 1.8 years of market history since June of 2007 (the end of the data used in the analysis) and we have lived through the massive dislocations of the volatility shock. The ‘great moderation’ theory looks like a bad joke. This period amply reinforced the notion of a negative correlation between return and volatility. It is instructive to look back at how the stocks proposed for managing a volatility shock performed. An equal-weighted allocation to the stocks from my article titled Portfolio Management in Increasingly Risky Markets generated an average annual return of -17.1% from July 2007 through March of 2009, assuming annual rebalancing. A portfolio that was allocated equally between the EAFE index (EFA) and the S&P 500 (SPY) has provided an average annual return of -35%, with slightly higher volatility than the portfolio of individual stocks. Even though correlations between all asset classes increased as the markets declined, the portfolio of individual stocks specifically selected to limit correlation to VIX substantially out-performed the broader market.
When volatility was low in 2007, there were several clear strategies for managing the potential for a volatility shock. One approach, of course, was to buy put options on major portfolio holdings. The options market was already pricing in about a doubling in market volatility at the time, however, so these options were not cheap. In retrospect, of course, we can see that these options would have paid off handsomely, but that is not very relevant. During the volatility spike, a very profitable strategy was to sell call options, and I wrote about this strategy in November of 2008. Another strategy is the one outlined above: select investments that have low correlations to VIX. While the sample portfolio of stocks shown above has lost considerable value, it has performed far better than allocations to major indexes. A final option for dealing with rising volatility is the new ETNs that track VIX, like VXX and VXZ. These new investment options were not available when I wrote about this topic in 2007 and before—they were launched in early 2009. These could provide an interesting way to manage potential for rising volatility when next we face a high potential for a volatility shock.
The greatest lesson from 2008 was simply that so few people, it seems, paid attention to the market signals that were provided by market volatility and implied volatility. Or, to be more specific, people assumed that low volatility was going to be a permanent feature of the landscape rather than simply part of the cycle. As Grantham noted, this led to a bubble in risk. With volatility low, investors took riskier and riskier bets—in essence betting that volatility would not return, even as the options markets clearly suggested that this would not be the case. This is a classic example of the “availability heuristic” that drives all bubbles: people simply assume that “it’s different this time” and that things will continue as they have in the recent past, discounting long-term historical evidence.
Today, while market volatility has dropped substantially from its highs of 2008, it is still high—more than double the long-term average for domestic equities. The implied volatility in long-dated options is quite close to the implied volatility in near-dated options. With no trend in implied volatility over longer-dated options and with this level of implied volatility being so high, mean reversion suggests that volatility will drop over the next several years. This is a good sign for equities, in general. As volatility drops, the negative correlation between returns and volatility will benefit investors just as it hurt them during the volatility shock. There are substantial inconsistencies in the pricing of risk (as reflected in options prices) that can be exploited. I see management of portfolio volatility and correlations of portfolio returns to market volatility as key areas that investors and advisors can use to performance. Risk and return are the two sides of the investing “coin” and to ignore the information content in volatility is to miss a key ingredient for portfolio management.
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This article has 12 comments:
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My next thought is to perhaps start selling some puts here and there. Worst case if exercised, you're picking up shares at a healthy discount to present values (as long as you're not catching a falling knife and testing new lows!).
High volatility means beaten down stocks can easily jump 2x to 5x during bear rallies. In some cases 10x or more in one jump alone.
Technique is to buy beaten down stocks using price divergence signals. When they jump - sell 1/2 of the holdings at 2x or more. This makes the other 1/2 holdings basically risk free with extra profit for the effort if it goes more than 2x. Hold the other half as long-term investment and sell at 10x or 20x or even 50x depending on you time-frame.
Dangerous game because those beaten down stocks can easily go bankcrupt.
Not so dangerous while the downturn is still young and companies less likely to go bankcrupt with their cash reserves that can last more than 2 years.
Also, this technique requires considerable knowledge of and experience in technical analysis.
Some of the stocks I traded during the first bounce off July 2008 were ABK, AMR, and JBLU. There were few pickings at that time and I even got crushed by CC and PIR.
During the Oct 2008 meltdown, MS, OMX, ODP among others got crushed so badly even their weak bounce produced more than 2x but timing was extremely hard to execute since the momentum to the downside had dramatically increased with more than 90% chance of further lower lows. I got crushed with SIRI.
The Nov 2008 follow-up sell-off was predictable and a lot easier to anticipate due to the exteme downside momentum that was generated in Oct 2008. GM, F, DRYS, C, BAC, TASR, etc. were beaten down so badly that their reactive rallies proved to be more than 2x. Some even went 5x or more.
Jan to March 2009 major sell-off was the much anticipated final leg to the May to Oct 2008 market meltdown with a target of SnP 600. It did'nt happen since the BKX was already finalizing the last legs of it's run down on the weekly chart.
So, I bought a lot of Financials including C, BAC, XLF, UYG, STT, STI, etc. It proved to be a perfect timing on sector analysis being able to provide the catalyst for a major reactive rally. BKX went up 75% just on the first bounce with C, BAC, UYG jumping up like crazy. I also bought GE which was heavily shorted at that time. It was also almost impossible to ignore the preponderance of extremely bad news at that time regarding solar firms and projections for more dire sell-offs. The news came out after the solar companies have already gone through a prolonged sell-off - meaning, investors have already priced-in the bad news before they got released. SOLR, ESLR, LDK were among those most damaged stocks. They jumped with joy on the first opportunity to do so. There were so many stocks sold off by shell-shocked investors during the Jan to Mar sell-off such as AFFX, AYR, ATPG, CBL, HLX are among others I simply can't buy anymore when I run out of capital. Using margin account was an alternative but with SnP still having a 600 target, it was extremely dangerous using margin account.
Now, why buy such trashy stocks in the first place? Why not simply buy strong and stable companies such as JnJ, MCD, AMZN, WMT, etc?
Trashy companies got hammered so badly due to extreme investor panic. They know very well those companies can easily go bankcrupt so they sold their stocks at any price. What they did not consider is that those companies still have some cash left to last them 6 to 9 months or more before they start considering bankcrupcy proceedings.
Sell half of the holdings at 2x or more and hold the other half as long-term investment. With basically zero cash investment on the other half, it does'nt matter if they go bankcrupt. If the economy recovers, those beaten down stocks will appreciate 5x, 10x, 20x, or more in 3 to 5 years.
Look at JnJ, MCD, AMZN, WMT. Strong and stable companies. How much did they jump since March 2009? 10%, 20%, 30%? How come? They are not volatile stocks, they simply cannot jump 2x or more.
VIX jumping to 89.53 in Oct 2008 generated extreme momentum to the downside.
What happens when extreme momentum is generated?
Stocks kept going down even if the momentum and/or VIX kept on tapering down.
Another major sell-off or capitulation sell-off (with VIX spiking up but lower than 89.53) will be needed to produce the divergence buy signal for stocks. It may take another 5 months to 9 months of bear rally consolidation before this can happen.
Buying beaten down stocks and selling for 2x can become extremely dangerous by that time since many of them will be running out of reserved cash.
Likewise, if the economy finally recovers, even if 7 out of 10 beaten down stocks go bankcrupt; the remaining 3 can jump 10x, 20x or more in 3 to 5 years after that capitulation sell-off thus making up for more than what had been lost in the 7. Skills in stock picking with fundamental analysis will prove very helpful when considering buying beaten down stocks by the time the capitulation sell-off happens late this year or early next year.
Best buys during the capitulation sell-off will be Financials - only if the Financials go higher high while SnP and/or Dow Jones go lower low. BKX went down 8 months ahead of the Dow Jones and SnP. It is expected to recover first before the major indeces which are supposed to suffer more from more extreme consumer spending crunchdown as the unemployment goes higher.
Banks control massive amount of money they borrowed from the government - they can control the government despite the administration's showing macho posturings. Since the US gov't have borrowed trillions from China and other major countries, those countries will also be at the mercy of the US.
Like what they say "Borrow $1 million from the bank and they control you. Borrow $100 million and you control them".
Ironic that the banks are doing the massive borrowings this time around at extremely low interest rates. The government may never lend them hundreds of billions or even trillions if they are not in big trouble as it is.
Banks would never lend individuals and companies money when they got into big trouble.
Told you, the world was never been round.
Also, what happens when inflation starts rearing it's ugly head?
If you can't beat them, join them.
Expect 100% or more price appreciation for strong and stable companies in 3 to 5 years. No worries for bankcrupcy, no rewards commensurate to risk either.
"An equal-weighted allocation to the stocks from my article titled Portfolio Management in Increasingly Risky Markets generated an average annual return of -17.1% from July 2007 through March of 2008"
It should read "through March of 2008." Sorry for the confusion.
There is a paragraph above that reads:
"An equal-weighted allocation to the stocks from my article titled Portfolio Management in Increasingly Risky Markets generated an average annual return of -17.1% from July 2007 through March of 2008"
It should read "through March of 2009." Sorry for the confusion.
On Apr 14 02:18 PM Thomas J. Gordon wrote:
> Just looking quickly at the portfolio that was suggested in 2007
> I would guess that it did not avoid severe losses in the big 2008
> downturn. I can think of only a few things a long investor could
> have been in that would have avoided enormous losses for august 2008
> on: shorts or puts on almost anything, treasury bills, japanese yen,
> and selling calls like you mentioned. I like statistics. I understand
> statistics. Did it help you here take less losses from august 2008
> on?
I look forward to the further development of your thesis. Hindsight is 20:20 but expectation of volatility (VIX) decreases when investors are complacent and increases when investors are scared.
Buffets classic line at work: "“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”.
You hear a lot of people claiming that indexes are stable with the S&P 25% higher in 25 trading sessions, yet I see it as evidence for a severe pullback given the obvious uncertainty of the U.S. equity market and thus overall volatility.
I enjoyed the article and would appreciate any feedback concerning derivatives of the VIX that may explain the volatility of the VIX itself and what that could tell us about the future of markets.
One query that I would have is when you suggest that we should expect "mean reversion" for volatility in coming years.
It could be that the risk landscape has been permanently changed by the more widely recognized fragility of the financial system and its pre-disposition towards moments of scary illiquidity.
While the magnitude of the "legacy" assets problem remains opaque I would doubt whether the VIX will return to the more subdued levels seen in the middle of this decade.
There is no reason that I can see that the world has become permanently riskier--anymore than the reverse was true when vol was low for 4 years or so through late 2007. People always think that recent experience is the best indicator of the future--but that is rarely the case. Do a Google on Minsky's instability hypothesis. It explains the cycles in risk takeing and risk aversion. I don't know when VIX will get really low, but I am betting that VIX will come down to 15% in a few years. Maybe, maybe not. My current vix plays look at relative pricing of options, not bets on absolute risk levels.
On Apr 16 04:27 AM morph366 wrote:
> Some very interesting points raised.
> One query that I would have is when you suggest that we should expect
> "mean reversion" for volatility in coming years.
> It could be that the risk landscape has been permanently changed
> by the more widely recognized fragility of the financial system and
> its pre-disposition towards moments of scary illiquidity.
> While the magnitude of the "legacy" assets problem remains opaque
> I would doubt whether the VIX will return to the more subdued levels
> seen in the middle of this decade.
Thanks for the future article ideas. A downward trend in VIX is generally good for equities--as I discussed in my earlier article on correlations to VIX.
The idea that the market is 'stable' is foolish--as you note. Implied vol is still high going out years on just about everything. BUT, the fact that vol has fallen and is still well above average sets us up for declining vix / implied vol and increases in equity prices as investors become less risk averse--but this is the longer term. Short-term, people are still highly risk averse so the possibility for a big sell-off is definately there.
On Apr 16 03:12 AM TraderRob wrote:
> The VIX can be used as a gauge of potential market growth over a
> 30 day period. Assuming that a very high VIX anticipates larger magnitude
> returns, wouldn't a sharp trend down in VIX over the short term be
> a signal that markets are overbought and that they have little room
> to the upside?
>
> You hear a lot of people claiming that indexes are stable with the
> S&P 25% higher in 25 trading sessions, yet I see it as evidence
> for a severe pullback given the obvious uncertainty of the U.S. equity
> market and thus overall volatility.
>
> I enjoyed the article and would appreciate any feedback concerning
> derivatives of the VIX that may explain the volatility of the VIX
> itself and what that could tell us about the future of markets.
Thanks for bringing up Minsky as he is one of the few economists who understood the inherent instability of markets. My suspicion is that even he would have been surprised by the severity of this current crisis.