Geoff Considine

Lessons from the Volatility Shock of 2008

Rob:

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.

Lessons from the Volatility Shock of 2008

Morph:

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.

Lessons from the Volatility Shock of 2008

The cumulative average annula return is through March 2009 (there was a typo that said 2008). So, yes, this portfolio vastly out-performed the broader markets through 2008.


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?

Lessons from the Volatility Shock of 2008

aargh--i'm all thumbs today:

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.

Lessons from the Volatility Shock of 2008

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 2008." Sorry for the confusion.

Stock Portfolio to Weather a Volatility Shock

I ran across this article by Morningstar:

biz.yahoo.com/ms/07051...

This article is about investing when you don't expect the broader market to do as well as it has in the past---but it never mentions that you can build an equity portfolio that is not too coupled to the broader market--as I discuss above. A select portfolio of equities can be designed that, while impacted by the equity risk premium, does not do poorly simply because the broad U.S. economy and / or U.S. market indices do poorly.

The ‘No Direction’ Portfolio: S&P 500 Outperformance With Lower Volatility

Hi Joe:

First, you are of course correct that just because this portfolio works in one bear market, it may not work in others. My point is that the R-squared and Beta over the last three and five years are also very low--this portfolio continues to be de-coupled from the broader market. This shows that the bear market performance is not some odd fluke. Further, the general themes here are sectors which have inelastic demand--i.e. demand for their products is not driven by the moves in the broader market. People need beer, and meat products, and electricity--regardles... of what the S&P500 does. Further, there is some behavioral finance here. There is an area of behavioral finance called heuristics that studies the short-cuts that people make in reaching decisions. One of the standard heuristics is called 'attribute substitution' and is more commonly referred to in the form of 'Choosing by Liking':

www.behaviouralfinance.../

In the current context, this means that people tend to think that an exiciting company will be a good investment while a boring company will be a bad investment. This is a well known investor bias. Nobody goes to dinner parties and talks about how they invested in Hormel because of its exciting business model--at least nobody I know:) The point is that there are some great investments available in boring businesses and behavioral finance explains why the value of these firms is not already'priced in'. This is my thinking on this issue--I'd love to hear from others.

The ‘No Direction’ Portfolio: S&P 500 Outperformance With Lower Volatility

Errata:

WM is Washington Mutual, not Waste Management, Inc., as listed above. The analysis used WM. Sorry.