Volatility And Volume: Not A Good Match, But The Candles And Embers Are Stilling Burning

Includes: DIA, IWM, SPY
by: Miles Hoffman


Volatility is increasing, both down and up.

Volatility elevates during bear markets, but the real volatility comes near the end, not the beginning of a bear market.

We haven't seen real volatility yet.

Market-Making News

Given heightened volatility, I have been including a chart showing market news in my recent sector articles, more for me than for you, just so I can remember what all the pundits are saying. It is important to note, I use the SPY ETF for this chart. Index charts do not show gaps correctly, like when individual stocks have difficulty opening. Since the S&P500 futures are always trading at the open, the SPY ETF will key off the futures and give you a generally correct interpretation of overnight gaps.

Chart 1 - Market-Driving Excuses News

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Another important point is I use candlesticks for this chart because they convey so much information. As I discussed last time, China and oil have been in the driver seat recently, with big moves coming over-night. This heightened volatility has also been visible intraday, with big intraday reversals. Technicians have names for the shapes of candles, from hammers, to a hanging man, and various stars of sorts. Naming the movements make them easier to recognize and understand. There have also been days of large directional moves, which have names in the technical world, but basically they are big, or long, solid-colored bars. Since the start of 2016, we have been living in "gap city," home to many bars and stars, and bears.

The volatility is easily visible in candlestick charts, especially if you know the names, but something I noticed right away was that as the market declined, volume rose. When the market tried to rally late in January, volume shrunk. You might assume, as I initially did, that holiday volume was responsible for the lower volume at year-end, so naturally volume had to begin increasing in January. Obviously, this is true but I would not call it a truism. Look at chart 2, which zooms out to see the past year. The stock market decline started near the beginning of December, about the same time as volume started increasing. The first 5 weeks of 2016 exhibited volume that I would say was about 50% greater than we saw in 2015, on average.

Volume and volatility up, together, is not a good combination!

Chart 2 - Volume Up with Volatility Up

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Note: The following few paragraphs have links to ZeroHedge, a site that cautions it is "intended for Mature Audiences." It provides reasonably good intraday news for news-starved traders trying to make sense of intraday volatility; however, it is very bearish and should be taken with a grain of salt.

Back in chart 1, I circled February 3rd in brown because I think it deserves special consideration. First, from ~7:55am until 8:15, the e-mini climbed about 5 points, or 0.25%, and then ADP released their employment report. In the next 10 minutes, the market dove right back down. After NY Fed Pres. Bill Dudley spoke, over the next 45 minutes, the market climbed over 10 points, or 0.5%, apparently be Dudley "hints at Fed policy error, and warns of significant consequences from strong dollar."

In chart 2, December the 16th is highlighted because that is when the Fed raised rates. The market apparently did not the increase very much; it declined sharply over the next two days, and while volatile, it has continued declining since then. Now that Dudley said it might have been a mistake, well, the market didn't like that either.

At the open, the market started dropping and was down almost 1% by 10am. At this point, the PMI/ISM data came out weak, and the market dropped another 1.5% in the next 30 minutes. This is a total decline of ~"45 handles," or points, in the first hour of trading (-2.4%). If you think that was not enough, it bounced back halfway back (1.2%) by 12pm, and then gave up 2/3's of that bounce back by 2pm. Wow, what a day… not yet.

The market was still down 1.9% from the open, and as traders know and many investors realize, around 2pm is when institutions really enter the market because they have a "trading book" that has to be finished by the end of the day. I cannot find what sparked the rally, but volume soared for 10 minutes or so, taking half this 1.9% loss back, and by 3pm, the market had retaken the opening price. It was a roller-coaster day that would make all but the most nimble traders sick.

Chart 3 - Dow Realized Volatility, intraday-adjusted

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In the Zero Hedge "roller-coaster day" link, Zero Hedge attributes the large up moves to short covering. Zero Hedge has chart 3 in the article, which shows an intraday adjusted volatility index, and it is back to levels associated with very poor market action. I have continuously discussed that heightened volatility is sign of a bearish market, but the VIX does not convey this intraday volatility, and I am not sure the VIX gives any real indication of things to come. It is not a leading indicator, the VIX is a co-incident indicator.

In chart 4 below, I show several volatility measures: the VIX, the average true range (NYSE:ATR) - a technical measure of volatility, and four versions of "gaps", which are just really price movements (the program started as overnight gaps, but I kept wanting to see more):

  1. Overnight gaps - from the prior day close to next day open.
  2. Close to Close - call it the "normal" measure of a day's performance.
  3. Day range - the high minus the low, so it is always positive.
  4. 2 Day range - difference between high and low across 2 days, and thus is positive if the low happened on the first day and negative when the high occurred on the 1st day.

The VIX is red and has black lines at 20, 40, 60 and 80. It is overlaid with the ATR, which is black and blue and has magenta lines at 1, 2.5, 5 and 7. It is calculated as a percentage of the prior days close, making it comparable over long periods of time when prices are very different. The histograms in the chart are the gaps, with Monday blue, Tuesday orange, Wednesday gray, Thursday green and Friday red. There are average lines there that might be hard to see, and there are 5 of them because I calculate the average for each day, with a default of 4 corresponding to roughly the number of times a day of the week occurs in a month. I also set the scale of each measure so that it encompasses the period back to 1993 when the SPY began trading, making it also comparable in each chart. It may be hard to see the chart details, but see if you notice anything (cntl+ and cntl- should zoom these charts a little).

Chart 4 - Volatility measures

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Chart 5 - Volatility measures

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Chart 6 - Volatility measures

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Chart 7 - Volatility measures

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Chart 8 - Volatility measures

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Right after noticing the high volatility at the end of bear markets, the next thing I noticed was that during the Tech bull market, the VIX became elevated during a bull market. Beginning in 1996, it started hanging around 20 and after the 1998 pullback, it mostly traded above the 20 level. The VIX spiked to the 40 level near the ending of the bear market in 2002. During the 2007-08 financial crisis, the VIX held on the north side of the 20 level beginning in mid-1997, and like all the volatility measures, it hit its record high in the fall of 2008, a few months before the final stock market bottom. During the 2010 and 2001 corrections, it spiked up and held above the 20 level for a few months, then entered a long lull in the "ruler" market. The August waterfall (crash) caused a sharp spike up but it fell back quickly. There was a minor pop up, but then the VIX declined back to very low levels. It now appears to working itself back up above the 20 level. The ATR follows the same general pattern as the VIX but it is calculated on a 14 (trading) day basis so it is quicker to settle down.

One always hope to find some holy grail to the market, and while the gap measure of volatility I developed helps in my option trading, it is no holy grail, but there is an aha. Crash Monday was an almost 6% move. Obviously 1987 takes the record, but these two stand out during bull market phases, even during the ending phases as we may be (are!) in now (caveat: Eisenhower's heart attack caused a big down day in 1955, but issues with overnight index gaps make comparisons difficult if not impossible). I checked GE (to 1969) and the August crash Monday seems to have been a big one.

A notable difference I see is that, assuming this is a top, like I do, is that this top has been very smooth but started with a bang (Aug'15). During 2000 and 2007, the top was more erratic. Still, considering this difference, the gap charts show a level of volatility at least matching the 2010 and 2011 corrections. Leading up to the 2000 top, it looks like the market was worried all the time. In 2007, the initial spikes occurred in March, and more in August, with the final top in late September starting a period of sustained volatility common in bear markets. Having stared at this chart for too long, it looks like we most resemble 2007, and that is a worry in and of itself.

None of what I discussed, however, was what I meant when I asked you earlier if you noticed anything. I am almost sure you cannot see it in these charts. Remember there are averages for each days gap. Blue Mondays appear to dominate, which would be expected as news emerges over the weekend, but Fridays can often be seen on top, especially this past October and with the recent correction. At one point in time, I made a lot of money day-trading expiring options on Fridays, but I stopped a few years ago when it quit working. Occasionally I've tried the same strategy but it has been hit or miss, and I tried recently and it took my head off. Now I know why. Fridays are experiencing big intraday swings, play accordingly.


If you have not read my articles before, there is a section below highlighting important investment concepts, and one of the most basic is that bear markets are volatile, down and up. Some of the larger percentage gains have been during cyclical bull markets that occur within a larger secular bear market. The important point, however, is that volatility in a bear is on both the upside and downside, like a roller coaster. How has this market felt for you?

There is a big debate as to whether we have entered a secular bull market. Secular bull markets are ones like those that started after WW2 and after the inflation-plagued 1970s. I do not think so based on fundamentals. The post-world war era ushered in a new prosperity, but at the cost was a Great Depression and many lives lost in the war. Reagan and Volcker also ushered in a new age of prosperity by breaking the back of a decade-long increase in inflation, at the cost of back-to-back recessions and record interest rates, and a lot of purchasing power lost to inflation.

When I look at the fundamentals today, I don't see that anything has really been cleaned up, nor has anything being done to clean it up. Saved perhaps, but not cleaned (swept under a rug for sure). Instead, I see the Fed, and that is about all I see. It lost control - or never had it - during the tech bubble, and when that bubble crashed, it rushed in to create a housing bubble. And when the housing bubble crashed, along with a commodity bubble of Chinese making, the Fed again rushed in to put out the fire. It did so by blowing real hard, but smoldering embers were buried under the mountain of money and seem to be reigniting.

Do you really believe that Obama and the RINOs, with the help of the FED, have laid the groundwork for a new age of prosperity? Even worse, do you see anyone running for President that you think will do so? Perhaps, but given the circuses in town, and the clowns now leading, it is hard to tell. I wonder if I should just vote for Bernie so we can finally bring down this house of cards. Maybe, and only maybe, then, could we really begin to lay the foundation for a new age of prosperity. Until then, I would expect a lot more volatility, and probably a lot more downside. And while I would welcome a crash, if it was a cleansing one, my portfolio strategy is best positioned for a slow, gradual decline.

If you are a new reader, or desire to follow me, I use my Instablog for quick notes, links, and charts where I don't have time for a full article. You have to sign up as "a real-time follower" to get e-mail notifications of Instablog postings. Regular followers will not be notified.

For New Readers

I have focused on the sector rotation model after writing my first article on Seeking Alpha, which was in response to an article that advocated rotating into safe sectors at the start of a bear market, even though the author could not tell if the waterfall crash of August 2015 was, in fact, the start of a bear market. It must be worth a read because it was an Editor's Choice article. I followed it up with two other primer articles that all investors need to know. As primer articles they are long; investing is a marathon, not a sprint, it takes preparation. Because my first article was a counter-argument to a Seeking Alpha article, my first 3 primers were written in reverse order from which they should be read; follow the numbers below:

1) Secular Movement in Interest Rates: Interest rates exhibit long cycles of up and down movement. Finance 101 teaches that the valuation of an asset (stocks+) is inversely related to the "capitalization rate" (or the inverse, depending upon the industry: it's PE ratios for stocks, "cap rate" and/or "gross rent multiplier" for real estate, etc). The market PE ratio is therefore directly related to the level of interest rates. This really is the starting point for equity investing, but far too many investors ignore it because they think it is not important, or is for bond investing. This article is basic finance 101 combined with the history of bear markets and panics.

2) Equity Markets - Secular Bulls and Secular Bears : The stock market also exhibits long cycles of up and down movement (often driven by interest rates). The caveat, bear markets are volatile, so much so that some of the largest stock market rallies actually occurred during bear markets. This article also makes sure you understand real return, after discounting for inflation.

3) "Sector Rotation in a Bear Market" : Being my initial article, much of what might have gone in #2 above was written in this article. It introduces:

(NYSE:A) percentage change charts, which show relative performance of different sectors (or could be stocks, etc), and discusses some of the problems with them.

(NYSE:B) it discusses misleading charts, where the wrong scale is used (log vs linear), or other misleading chart techniques used to enhance an author's point of view.

(NYSE:C) it discusses math; for example, how riding a stock down 50% and then up 50% still leaves you down 25%.

(NYSE:D) behavioral finance is discussed extensively, and how investors fool themselves due to biases in investing.

(NYSE:E) 2000 and 2007 bear markets are extensively reviewed from a sector performance perspective.

(NYSE:F) Ratio charts are shown, which create a buy/sell type signal relative to two different investments.

All these issues are critical to debunking the belief that you can "hide in safe sectors in a bear market," although sector rotation provides good clues as to what the professionals are doing. Individual investors can go to cash during bear markets, but professionals are paid to be invested even during bear markets. Consequently they move to safe sectors during bearish economic or market times. Following the sector rotation model can provide clues to where the stock market is headed, or at least, where the paid professionals believe it is headed.

Chart 0 below shows the sector rotation principle. For a quick read on understanding of the principle and causes of sector rotation, you can read the "Sector Rotation Background" in this article (at the very top), but I would recommend you skip it and go straight to the more comprehensive primer article #3 (after reading the first two).

Chart 0 - Understanding the Sector Rotation Model

Disclosure: I am/we are short SPY.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: My short position is actually a combination of bearish option strategies designed to make money on the downside, preferably slowly, but will make more money if we bounce slightly and in the perfect timing of the expiration dates of the options.