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SPX Volatility Extinctions 2

Adam Hamilton
June 26, 2004

From a speculator's perspective, 2004 has been one heck of a dull year so far in the US stock markets. The very volatility that usually creates the great opportunities to trade has been glaringly conspicuous in its absence.

Using the flagship American S&P 500 stock index as a proxy for the markets as a whole, the raw numbers tell this whole flatlined story. As 2004 dawned, the SPX closed at 1108. By early February it rallied to reach its latest interim high approaching 1158. Then it decayed and faded into mid-May when its lowest year-to-date close of 1084 was witnessed. This tight range of 74 points yields a minuscule trading range under 7% so far this year, amazingly low!

Just how amazingly low is this? Well, in closing terms the SPX swung 34% in 2003 and 34% as well in 2002. Thus, at this point in 2004 the S&P 500 has only run through 1/5th of the range witnessed in recent years! With the stock markets languishing in these surreal doldrums sans volatility, both the interest in trading and volume are vaporizing as speculators seek tradable markets elsewhere.

The art of speculation demands buying low and selling high, and when the markets stagnate they fail to provide the crucial low points at which to buy and high points at which to sell. The longer an episode of waning volatility persists, the more the general trading interest in a particular market fades. If you are not granted interim opportunities to either buy low or sell high at least a couple times a year or so, there is little point in spending time and effort to follow a dull market.

I have been marveling at this abnormally low volatility in the US equity markets all year. This week I would like to analyze and quantify this strange phenomenon. Is our perception of unnaturally placid markets backed up by the actual raw volatility data?

In order to execute this research, we decided to look at interday volatility, the actual day-to-day change in the closing price of the S&P 500. Unlike the mathematically complex implied volatility indices like the VIX, simple interday volatility is a much cleaner number since it does not rely on continually shifting options expectations running one month into the future. True volatility and implied volatility are both very useful and have their places, but this week we are using the true absolute interday numbers.

Provocatively though, the S&P 500 VIX and S&P 100 VXO implied volatility indices have just this week carved their lowest closing lows since the Great Bull of the 1990s. The NASDAQ 100 variant, the VXN, has plunged to all-time record lows. So while we are not specifically looking at the implied volatility indices this week, they also provide rock-solid evidence that 2004's abnormally low volatility is very real and not just in our heads. Truly something strange is afoot.

I last discussed absolute volatility in October's "SPX Volatility Extinctions" essay if you would like more foundational background information on these studies and their implications for speculators. Our graphs this week are modified updates of those earlier ones, focusing exclusively on interday volatility this time around.

Absolute interday volatility is calculated by subtracting yesterday's SPX close from today's and dividing the difference by yesterday's close. An absolute value is applied to this quotient to ensure all the resulting volatility numbers are positive and comparable. The dark gray lines below graph these raw numbers, which can fluctuate quite violently day-to-day. A 10-day moving average, drawn in red, is also applied to smooth the raw absolute interday volatility calculations.

Our first chart takes the long strategic perspective, examining interday volatility in both Great Bull and Great Bear markets since the late 1990s. It is provocative to note that not even when the S&P 500 doubled from 1997 to 2000 did we witness a similar period of extraordinarily low volatility as we have seen thus far in 2004. The hard data backs up speculators' perceptions of something weird transpiring today.

If you concentrate on the red absolute interday volatility 10dma line in 2004, it is apparent it has hovered around 0.5%. On average, so far this year the day-to-day changes in the US stock markets have averaged a trivial and not very exciting half percent or so! On a sidenote, when my partners and I talk about the markets each day as we work, we consider any daily move in any market of less than 1% or so to be "unchanged", not even worthy of consideration in isolation. Most of 2004 has slumped under this key metric. Yawn.

In fact, if we average the interday volatility for the first half of this year, we arrive at an average daily move of only 0.58% for the S&P 500. This number, along with the annual average interday volatility numbers for all of the years shown in this graph, is noted above in yellow. We'll delve further into these yearly averages below, but for now just realize that 2004's unnatural serenity has been far more pronounced than even during the Great Bull years of the late 1990s.

Why is volatility so important to consider? As I outlined in my original essay, it is one of the best proxies for general greed and fear in the marketplace as a whole and hence tends to mark major interims tops and bottoms remarkably well. There is no more powerful force driving short-term market movements than this general greed and fear among speculators as a group.

If you carefully examine every major SPX interim low in this graph, during both bull and bear, you will note that they all corresponded with big spikes in interday volatility. Conversely, major interim tops coincided with periods of low volatility. If some visual guides would make this easier to see, the first graph in "SPX Volatility Extinctions" has vertical lines drawn in to connect these volatility episodes with the respective interim turning points which they flagged in the S&P 500.

Volatility quantifies general speculator emotions so well because it captures the behavior of traders at turning points, and this behavior is driven by emotions. The greed and fear that drive the short-term markets are asymmetrical, with fear being a much more powerful and urgent emotion than greed. While greed nurtures itself gradually, fear ramps up very fast once speculators feel they are in danger of getting really hurt and losing big.

To illustrate this market truism, imagine the behavior of a group of tourists visiting one of those enormous Las Vegas casinos on the Strip. As the tourists wander through the casino floor, they see other people winning money so they get interested. After observing a bit they are sucked into the glitz and glamour and are ready to gamble. They sit down, relax, play the games, and visions of wealth dance through their heads. Speculators in the financial markets act the same way, biding their time initially and only growing greedy once they see someone else winning so they want a piece of the action for themselves.

On the other hand, what if this same group of tourists was in the casino when a cell of terrorists armed with AK-47s and grenades burst through the doors and started randomly shooting people. God forbid, but the black fear would be overwhelming and everyone would instantly forget gambling and jump up and scramble for the opposite doors, creating a stampede. Once people fear for survival, their own or their capital's, fear wells up instantly and the need to escape becomes blinding and all-consuming. In the financial markets this flaring fear coincides with the heavy selling at major interim lows.

In the stock markets volatility acts as a proxy that quantifies general greed and fear. When the markets are up and others are winning like at the casino, greed waxes extreme among speculators. Trading tends to be less aggressive as everyone relaxes and enjoys the ride. Without heavy trading, volatility gradually shrinks towards oblivion as greed rules. Naturally though, as all contrarians know once greed grows too great an interim top will be reached and a correction or downleg will be necessary to burn off the greedy speculative excesses.

Once these corrections or downlegs run their courses, general sentiment is overwhelmingly negative as a major interim bottom is approached. As fear soars, speculators grow frightened and run for their lives much like the tourists would during a terrorist attack at a casino. Heavy panic selling leads to a great increase in volume and an explosion in volatility. And just when things seem like they are never going to get any better again, the capitulation ends, volatility plunges, and the next rally or upleg can rise like a phoenix from a clean sentiment slate.

This pattern is fascinating as it holds up flawlessly in both bull and bear markets. Emotions are powerful forces, but they only react over the short term. Thus, an endless torrent of tactical emotional waves running from greed to fear and back again cascades through the markets constantly, regardless of whether the primary long-term trend is bullish or bearish. The chart above really drives home these crucial speculation concepts.

Therefore from a contrarian perspective the prudent course of action when popular greed swells and general volatility nears extinction is to sell and plan for an approaching correction or downleg. Bringing this analysis full circle, right now in 2004 we have seen the lowest volatility levels in about a decade or so. Low volatility always betrays extreme greed, an environment much like today's when the vast majority of players expect the markets to catapult higher. Yet, these very greed/volatility extremes tend to mark major interim tops, the time to sell or go short.

While the nearly year-long unnaturally low volatility stretch through which we are sojourning today is certainly unequalled anywhere else on this chart, it is really provocative to note the only other place which came close. If you examine the 0.5% line relative to the red 10dma above, you will note that the only remotely comparable volatility period was the notorious summer of 1998.

The summer of 1998 was initially much like today, with very positive general sentiment and a complete lack of fear coupled with the usual vacation-months slowdown in trading. The past year had been very kind to stock-market investors and Wall Street predicted great gains ahead. All it took was an unforeseen exogenous event, however, to shatter this bubble of complacency and pummel the SPX 19% lower in a matter of weeks.

Devaluing currencies and a Russian default on its sovereign debt led to enormous problems for hyper-leveraged derivatives players like the elite hedge fund Long-Term Capital Management. LTCM's spectacular implosion, of course, frightened Wall Street and the Fed so badly that they engineered a bailout lest the derivatives fireworks spread and endanger the entire US financial system. While the low volatility in stocks did not spark this crisis, it did provide the perfect backdrop of complacency and low volume to greatly magnify its impact on the markets.

The past year or so has been even worse in terms of greed and complacency than the summer of 1998! For a lot of reasons including the upcoming US elections, speculators just seem to generally believe that the stock markets can only move higher. However, as contrarian speculation theory states, the very times when consensus is vastly in favor of one particular direction is when a sharp move in the opposing direction becomes most probable.

A topping market on low volatility is very fragile and highly susceptible to a catalytic shock from some unforeseen exogenous event. We are certainly in this fragile zone now, and while no one can know what potential surprises are approaching over the horizon to spark the fear that will pop this sentiment bubble, we can know that the risks are extraordinarily high. In both bull and bear alike, very low volatility levels are harbingers of a coming major correction or downleg, not higher markets ahead.

If we zoom into this chart to just encompass the market action since the beginning of 2003, the amazing volatility lows and decaying topping pattern in the S&P 500 become even more apparent. The yellow numbers on the left show the average daily interday volatility of each of the past seven years in reference to 2004 year-to-date. It is certainly ominous to realize that 2004's average volatility is running far below that of even the greatest bull years in memory, the late 1990s.

The Great Bear years of 2000, 2001, and 2002 witnessed average absolute interday volatility of 1.12% in the S&P 500. As expected since greed and fear are asymmetrical emotions, the Great Bull years of 1997, 1998, and 1999 had a lower average interday volatility of 0.89%. 2003, not a secular Great Bull but a definite cyclical bull, weighed in at a very similar 0.83% in volatility. All of these numbers make sense in light of the way volatility works, until 2004 enters the scene.

Year-to-date, we are only running 0.58% in average absolute interday volatility in the SPX. This number is stupendously low and arguably flags one of the most overly complacent markets in modern history. With 2004 volatility only running about 2/3rd of what we would expect during a typical bull market, the probabilities of this being a major interim top grow very high.

The technical picture certainly supports these topping arguments as well. In S&P 500 terms, the blue line shows the decaying downtrend channel in the SPX in 2004. The US stock markets are gradually making marginally lower highs and marginally lower lows. Meanwhile the 50dma and the 200dma of the SPX are converging. The next minor selloff in the S&P 500 could very well take it below its key 200dma bull-market support just under 1100 now.

And while the S&P 500 appears to be topping, volatility is flatlined along that incredibly rare 0.5% interday 10dma line. While 0.5% has been touched about a dozen times in the last decade or so, it is extremely odd to see volatility remain near or under it for almost a year straight. The red technical lines framing the volatility 10dma trend really highlight this flatlined hyper-complacent development.

Another interesting observation involves the actual raw interday volatility data itself, drawn in gray above. In 2004, the highest absolute volatility days have only run around 1.5% or so. This compares to high days of 3% to 4%+ in normal bull and bear markets. Even on the most "extreme" days so far this year, the extinction of volatility becomes apparent and really sticks out like a sore thumb.

Why is volatility so low? I suspect it is probably at least partially because of the powerful election-year propaganda that Wall Street has been so zealously advancing this year. All day long we hear on CNBC and read in the financial newspapers how election years are generally positive for stocks. Never mind the last election year of 2000, which finished down by the way. After enough repetition of this election-year-bullish mantra, true or not, bulls get lulled into complacency so they don't trade and bears just stand back so they don't get hurt.

A lot of folks believe active manipulation is happening in the SPX futures to attempt to steer the US markets in a tight trading range at worst leading into this autumn's elections. The usual suspects are believed to be responsible, the Fed and/or the Working Group on Financial Markets (aka Plunge Protection Team the Wall Street Journal talked about following the 1998 crises). Not being an SPX futures floor trader myself, unfortunately I can't know for sure either way on this, but I do know without a doubt that for unknown reasons 2004 has been unnaturally calm.

Whether these surreal volatility doldrums are a consequence of herd psychology or active engineering, the longer they last the higher the probability of a serious correction or downleg becomes. Sentiment in the financial markets is like a great pendulum, the farther it swings towards greed the more momentum it gathers so the farther it will careen back into fear once it reverses. Like a rubber band can only be stretched so far before breaking, there are finite limits to popular greed and complacency.

Disregarding the disturbing volatility extinctions today, the headline markets appear to be relatively strong with little risk involved. I suspect this is what most American investors feel today, high complacency and little fear that prices are going to fall leading into an election. But when volatility and other sentiment indicators are considered, complacency and greed are far too high. These are the exact market weather conditions we would expect before a major fall.

In general, in bull and bear alike, low volatility is a telltale sign of major interim tops, not bottoms. Just when greed and complacency wax the most extreme, the markets tend to correct or fall to bleed off these unhealthy speculative excesses.

Just as many speculators have sensed, the raw numbers absolutely back the observation that volatility levels in 2004 have been off-the-map low. These strange developments are no doubt important and should not be taken lightly.

With today's anomalously low volatility, it sure appears like probabilities massively favor the thesis that we are witnessing a major interim top in 2004. If low volatility marks major interim tops, then isn't it logical to assume that unnaturally low volatility marks even bigger major interim tops as well?

I don't know what the catalyst will be that pops this massive bubble of complacency boiling in the US stock markets today, but it is probably stealthily approaching over the horizon. Please be careful on the long side until we see how this peculiar anomaly manages to resolve itself.

June 25, 2004
Adam Hamilton, CPA
email: zelotes@zealllc.com

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