Thesis: stock market volatility will abate and remain at a generally lower level starting in the second half of 2009 (as in right now) and going forward for the next several quarters-andperhaps all of 2010 or even longer.
During many periods of economic chaos, uncertainty becomes so widespread that panic sets in, causing market price volatility to dramatically rise–sometimes at mind blowing speed. The global recession that began in 2008 is certainly no different than any other period in terms of spiking stock market volatility as a result of fairly widespread panic. There is a reason the VIX index is referred to as the “fear index”. As it turns out there is an excellent leading indicator to forecast stock market volatility.
The following chart is a graph of the inverse 2-10YR yield spread (shown in blue) with the 6 Month Moving Average of the VIX (shown in yellow). The 2-10YR yield spread is actually lagged by 2 years–which essentially means the 2-10YR yield spread actually tends to predict the VIX (a.k.a. stock market volatility) two years in advance. If this is not clear let me spell it out like this...the 2-10YR yield spread today has predictive power for the VIX 2 years from now. I must acknowledge that this was not an original thought of mine. I viewed this graph for the first time a few days ago in a publication by Rajiv Shetty of Harcourt AG. I then recreated it so that I could show it here.
The graph, shown above, shows the persistent relationship between the inverse 2-10 yield spread and the volatility of the stock market since 1988. It is of course a longer term prediction which is to say that I am not interpreting this relationship as "the VIX will fall in the next week" or even month. But I do interpret this relationship to mean there is a strong likelihood that the VIX will abate for the second half of 2009 and that is likely to persist throughout 2010 and on into 2011.
What are the implications for financial markets if my forecast for the VIX to fall plays out?
The chart shown below is the 1 month change in the S&P 500 compared to the 1 month change in the VIX from 1986 through 2009 to date. As you can see, there is an inversely correlated relationship–which is to say that as the VIX rises, stock prices fall, and as the VIX falls, stock prices rise. So if my market call on volatility does play out, I would naturally expect there to be some additional upward pressure on stock prices going forward. Of course just because volatility abates does not necessarily mean that stock prices have to move upward. It might be the case that volatility abates which simply causes stock prices to exhibit trending behavior in either direction-up or down.
How can investors play this market call?
There are a few ways to express this view depending on investor preference.
The first approach would be using the newly created exchange traded note on the VIX put out by Barclays with the ticker symbol VXZ. The following chart is a scatter plot of VXZ in comparison to the VIX index (daily changes since VXZ came public on Feb 20, 2009). As one would hope, there is a strong direct correlation between the daily change in the VIX and the daily change in VXZ.
Given this relationship that VXZ does a fairly good job of capturing the market risk it is designed to capture (i.e. the changin the VIX index), investors may choose to go short VXZ shares, assuming there are shares of VXZ out there to short (which frankly I do not know).
The second approach, depending on how an investor feels about stock prices, could be to go long a buy-write index via an ETF like ticker symbol ETV. If an investor didn’t particularly feel compelled to go strictly long stocks with the added risk component of short volatility, it might be compelling to go long ETV and short SPY for a relatively solid market hedge (if an investor was trying to somewhat isolate volatility risk). Based on my prediction of volatility abating I would expect the persistence of ETV’s outperformance of SPY to actually increase in the coming quarters and perhaps out through 2011.
The third approach to short volatility, for the average investor (that I will mention), is to simply short calls against any stocks held in the investor’s portfolio. While this isn’t directly the same risk exposure to being short S&P 500 volatility, it is probably a fair assumption that volatilities for individual stocks and volatility for the entire stock market will tend to move directionally together over the medium and long term. As such, if there are certain stocks investors are bullish on, it seems compelling to me to add a short volatility risk component to those stocks.
So the theme here is: stock market volatility, as measured by the VIX, will abate for the second half of 09 and on through 2010 and perhaps even into 2011.
Disclosure: Long PCU, VALE, NUE, PSEC, HERO, ETV, and VLO (calls), short SPY.