Volatility is volatile (pun intended). In the last two years, we have seen relatively subdued levels of stock market volatility, which is normal considering we were in a bull market. Just a few volatility spikes during mild pullbacks scared nobody. For the most part, VIX traded below 20 with a few exceptions. However, starting this year, the VIX never went below 15 and exhibited higher lows and higher highs even before the major market sell-off in April. This was a major warning sign that the market is not as calm as we are used to. Here is a chart of VIX:
The early April decline was so violent that it sent the VIX all the way up to 60. This happens once every few years. While it seems extremely high, it reflects the real movement of the S&P 500 index. After all, we have experienced a couple of down days of over 5% and an up day of 9%. This is volatile!
Volatility is often calculated using variance and standard deviation (the standard deviation is the square root of the variance). Since volatility describes changes over a specific period, you simply multiply the standard deviation by the square root of the number of periods in question.
Annualized volatility simply takes a square root of 252 (number of trading years per year), which is roughly 17. So, VIX at 17 means the expectation is for the market to move up or down no more than 1% a day, 67% of the time (one standard deviation). Subsequently, VIX at 34 means 2% a day, 67% of the time, and so on… In other words, when we reached 60 earlier in April, the market expected to see about 3.5% moves every day, which is about right.
The market has rallied back to the 200-day moving average. VIX went down as expected and now trades at 22.68. During regular times, VIX futures are trading in contango. Contango is when the VIX is lower while futures are progressively higher. During stress and bear markets, VIX futures are trading in backwardation. This is the opposite of contango – VIX is higher, while futures are progressively lower. The chart below illustrates that we are still in a backward position despite the market’s coming back. In other words, smart money doesn’t believe our problems are over. VIX is a dashed green line. Monthly VIX futures is blue line.
If a major trade deal with China is not done ASAP, Stock and Bond prices will not even come close to discounting the underlying forces at work.
Our government’s flip-flopping policy has lifted volatility in markets and accelerated Global flows out of US assets into international assets, Gold, and short-term Treasury Bills. We believe that volatility will remain elevated for months to come. The uncertainty created by the government will fuel more knee-jerk reactions, sudden outsized movements, and high options prices. This is great for traders but not so much for investors.
