Summer Preview: Expecting More Volatility

We’re talking stock volatility as well, not just the implied volatility in the options indexes. Mark Hulbert compiled data showing that the May-October period, which typically underperforms the October-April period anyway, fares even worse when the latter period has been weak:

The stock market’s summer returns have been far more volatile following losing winters than winning ones. Consider the standard deviation of the Dow’s summer returns, which is one of the primary ways in which statisticians measure volatility. Following winning winters, this measure came in at 11.58, while following losing winters it was 16.12 — or 39% greater.

The bottom line? This summer is likely to be an even less favorable environment for the stock market than it is normally. But, in any case, it is likely to have above-average volatility.

In other words, fasten your seat belts, and hang on for the ride! (MarketWatch)

This fits in nicely with the expectations of everyone who thinks that there is likely more bad news on the way, that housing hasn’t bottomed, that the job market isn’t actually doing so well, and that there’s nothing traitorous about calling a recession a recession. It’s also hard not to look at the chart at right of the 30-day historical volatility in SPX, and not expect actual stock volatility to perk up.

Over the past year, the distribution of the 30-day historical (i.e. realized) volatility in SPX has centered around the 16-24% range (cf. second chart at right). The index’s current reading of 17.61 is at the low end of that range. There has been a much-discussed similar phenomenon taking place in the VIX, where we’re seeing consistently lower lows.

The question now is whether both implied and realized volatility will continue to drift lower as markets power higher, or whether we see enough selling pressure come back into vulnerable sectors to generate some real fear. As things stand now, investors - both institutional and retail - seem more complacent than they’ve been all year, and it remains to be seen whether that confidence will be rewarded.

One noteworthy signal is the increasing distance between the VIX (18.18), which measures the implied volatility in front month SPX options, and VXV (19.53), which gives a three-month estimate. Given how similar these two products are, gaps this large are difficult to sustain. When the VIX:VXV ratio reverts to its mean, it will most likely be because short-term volatility has picked up in response to some substantial selling pressure.

Reversal Readings

We haven’t had a look at the overbought/oversold readings for while. Here are some select readings:

• DIA - 98.35
• SPY - 92.35
• IWM - 63.72
• QQQQ - 92.98
• EEM - Emerging Markets - 95.7
• XLE - Energy - 70.28
• XLF - Financials - 95.90
• FXI - China - 99.32
• EWZ - Brazil - 95.61
• EWA - Australia - 97.56
• XLU - Utilities - 96.10
• BND - Bonds - 19.97