Observations & VIX Interpretation

Fig 1: S&P 500, VIX, ATR(20), and ATR(20)-VIX Difference Histogram

The VIX is an indicator distributed by the CBOE which uses the out-of-the-money put and call prices for the front and next months to forecast implied volatility for the next calendar month.

The reality, however, is that it’s largely a reflection of the past calendar month.  This is demonstrated by plotting Wilder’s Average True Range (ATR) of the past 20 trading days (approximately one calendar month) against the VIX.  The shape of the two curves are almost exactly the same.  The divergences are in magnitude, and the apparent under-pricing of risk in 2000 and 2008 are very interesting.  Consequently, I’ve plotted a histogram of the difference between the two.

The VIX At Bottoms

Despite its most obvious usefulness more as a mirror rather than a crystal ball, the VIX has served as a bottoming indicator for both strong secular declines in the past decade.

2003 Bottom

2009 Bottom

Observe that in both instances, the VIX peaked before the ultimate bottoms in price & time.  Options writers are the most sophisticated of investors, and they clearly bet on the bottom.  Perhaps it was obvious to them what is obvious now:  oil, gold, silver and Asian equities were well off their ultimate November and December lows.

The other supporting theory is Max Pain Theory, which theorises that since options writers are the most sophisticated (and likely the largest) players, they will simply manipulate the market to make the most money.  Max Pain is the closing price at expiry of a security which gives the largest total payout to options writers.  I haven’t seen or conducted a study on the forecasting power of this, but I wouldn’t discount it as a vector of influence on equities;  the necessary supporting data that options writers make out like bandits was covered in depth by CXO Advisory.

State of the Global Markets

Macroeconomics

Macroeconomic data remains uniformly off its peak values.  Unemployment statistics see a slowing in declines, showing only 216,000 NFP jobs lost on Friday’s report, but other measures like withholding and discouraged workers continue to climb.  The market is viewing this surprise news positively, so green shoots are still in vogue.

Plenty of important new data is coming out this week around the world:  British manufacturing production, Canadian rate announcement, building permits & housing starts, Australian home loans & retail sales,  New Zealand’s central bank rate announcement, Chinese trade balance, and American unemployment claims & trade balance.  I would expect that the lessening negative momentum will continue, and that will be reacted to tepidly by global investors.

Global Market Momentum

China

Almost every stock market is channeling upwards.  It looks like China — a laggard in the past two months after 100% run-up since November — might be finished its correction.  The Chinese economy & stock market are largely credited for lifting the world out of recession, and it stands to reason that weakness in China would probably pull everyone else down into deflation oblivion again.  I would put the odds of that quite low:  central bank & governments around the world have demonstrated a relentless commitment to reflation, and the threat of more money printing & stimulus will likely temper any aggressive selling tendencies.  The danger is in the Chinese real-estate market toppling as China apparently tightens lending standards to curb urban inflation.  This is a real risk, but probably won’t introduce economic volatility for a few months.

Commodities

The Dow Jones Commodity Index is up only +22% from its lows.  Oil has bumped its head repeatedly around the $70/bl mark.  I expected this, and expect this to continue as new supply becomes available from projects which become progressively more economically viable as energy prices increase.  Tepid growth and increased supply make oil a poor short and intermediate term investment, in my view.

Silver finally lifted off and rocketed past the $15 and $16 levels.  As was mentioned on Macro Hour on StockTwits.tv last night, the gold/silver ratio is a very heavily defended area that makes silver a very compelling purchase to the price-action inclined.  I’ve been buying silver since the sub-$9 levels based on the relative value, and it looks like taking profit might soon be an attractive option for me.

Natural gas continues to be a freak show, sporting a massive contango, production & development breakthroughs, storage challenges, and the destruction of American demand.

US Treasuries

The US treasury market tells a pretty different story to silver & equities.  Despite record borrowing this year, the 10y is still only 3.44%.  Yes, it is substantially off its insane low of 2.04%, but it is absurdly low in any growth scenario.  Either traders are pricing in a significant deflation risk not reflected elsewhere, or the debt monetisation is responsible.  Even the long end of the curve seems to be following a very consistent down-trend.  The likely scenario is a precarious balancing act by the Federal Reserve to keep mortgage rates down in an attempt to stimulate the economy despite money leaving for equities and commodities.

S&P 500

Financial valuations remain quite expansive (JPM at 132, BAC at 38.84, etc), while mainly traditional large cap technology growth stocks look like value stocks (MSFT at 15.2 and T at 12.63).  Priced for their forward earnings, almost everything looks like a value stock:  JPM at 14.02, BAC at 17.44, MSFT at 12.76 and T at 11.39.  Earnings day performance is all over the map.  If the surprises continue, we will get higher stock prices.  I think there are some great deals, especially in the seasonal consumer discretionary area as they traditionally bottom before Christmas.

Strategy

Reflation is continuing as planned.  I am fluent in good arguments which support a stronger September/October, but history & statistics are simply not indicative of much strength here.  I am still invested in things which have the best long-term prospects:  American poverty from a massive transfer of wealth to bank balance sheets, and the resource contention from a strong Asia.  I think there’s ultimately an expiry date on reflation, but there is a persistence of positively interpreted macro-economic data and asset returns, so while that train is moving up the mountain, I want to be on it.