US markets seem bent on teaching investors the meaning of volatility. August marked the only time in history that the Dow Jones Industrial Average swung more than 400 points in either direction for four straight days. It has now fallen nearly 9% since the beginning of the month.
Most stocks are getting pummeled, but there is one beneficiary: the CBOE SPX Volatility Index (VIX). The index measures the market’s expectations of volatility in S&P 500 stock index option prices over the next 30 days. Some say it shows investors’ level of fear (indicated by a high reading) or complacency (a low reading). It hit a one-year high of 47.56 earlier this month, indicating that the market is nearly brimming over with apprehension.
Most buyers of this index are using it as a hedge for a larger portfolio, but studies show that it may also be a good indicator of the direction of the S&P 500. A chart of its five-year performance shows three major spikes – in October 2008, when Lehman Brothers collapsed, in May 2010, the so-called flash crash, and earlier this summer, when the S&P downgraded US debt. A high VIX is usually thought to herald a rally, and investors are watching closely now for a decline that could indicate the start of a bull recovery. When life gives you lemons, squirt them on lobsters.
The nasty thing about volatility, though, is that it continues to evade prediction. Academics have fiercely debated models for forecasting volatility for decades, but no better measure has emerged than standard deviation. When visibility is low and uncertainty is high, markets can trade wildly for long periods of time. Technically, a high VIX is not necessarily bearish; it could also indicate the approach of a sharp upswing.
Among the financial crisis’ few beneficial effects was a reminder to guard against complacency. Former trader Nassim Taleb has helped to publicize this idea in his book “The Black Swan,” where he argues the futility of trying to forecast future events – extreme outliers like the rise of the internet and World War 1 play a much larger role in history than predictable occurrences, he writes. Concerning volatility, Taleb perhaps said it best in the title of a paper he published in 2007: “We Don’t Quite Know What We are Talking About When We Talk About Volatility.”
What is volatility? Perhaps, like pornography, it’s something we recognize when we see it – or when it is firmly in the rearview mirror.
For China stocks, volatility has certainly declined in the last month. The CBOE China ETF Volatility Index, which tracks an index fund that holds shares of some of China’s top companies, including China Mobile, China Construction Bank and CNOOC, has fallen sharply since the beginning of August. That’s perhaps because foreign investors have bigger things to worry about – like their own economies.
