January 20, 2016

Volatility

You’ve heard the saying that’s it all in your perspective. It applies to volatility.

Volatility is up 150% since the post-financial-crisis nadir of 10.32 for VIX Volatility in mid-2014. The “Fear Index” closed yesterday over 26, the highest since August 2015 when it topped 28 (way below 43 in 2011 and nearly 80 in 2008). VIX expirations are hitting today.

I’ve been seeing Mohamed El-Erian, whom I admire, chief economic advisor to Allianz and former right hand to Bill Gross at PIMCO, also now gone from the bond giant, on the business TV circuit saying central banks are ending programs designed to dampen financial volatility.

I think he’s got a point, and he means they’re starting to broaden trading ranges in everything from interest rates to currencies (as if we want them setting prices). But volatility is price-uncertainty reflecting evolving valuation.  Conventional measures often fail to reveal change because behaviors in markets morph while the metrics used to understand them don’t.

Figure 1

Figure 1

I can prove it.  In the first chart here (Figure 1), a small-capitalization technology stock on the Nasdaq hasn’t moved much in the year ended Dec 16, 2015 (I’ll explain that date shortly) but the stock rose from a 200-day average price of $20.67 to a five-day mean of $21.05, up 1.8%.  Not too great – but the Russell 2000 Index was off 1.3% in the year ended Dec 16, 2015. Perspective matters.

Now notice:  Daily volatility, or the difference between highest and lowest prices each day, is greater than the change in average price in all four periods.  Think about that. The price changes more every day than it does in moving averages for months and quarters.

Now see Figure 2 showing short volume Dec 1, 2015-Jan 15, 2016 for the same stock. The upper half is long volume (owned shares), the bottom short volume, or rented stock. The blue line is closing price. The data further back show short volume over the trailing 200 days averaged 60.2% daily.

Figure 2

Figure 2

Combine the charts. The stock moved less than 2% on average over the entire period but 60% of the shares trading every day were borrowed, and the spread between high and low prices was nearly 3% every single day.

Do you understand? On the surface this stock is not volatile. But up close it’s torrid – on rented shares. For a solid year, traders have kept this stock in stasis by borrowing and trading, borrowing and trading, because the cost of borrowing was substantially lower than daily price-movement. That’s market-neutral arbitrage.

Everything changed recently. Short volume in Figure 2 plunged Dec 22, 2015.  On Dec 16 (here’s that date now) the Federal Reserve bumped short-term rates to 0.25-0.50%. On Dec 17-18 vast swaths of interest-rate swaps tied to options-expirations lapsed. On Dec 21, the new series of options and futures (and interest-rate swaps) began trading. And on Dec 22, our small-cap’s short volume imploded, finally landing at 33% Jan 11, down from 71% Dec 10, a decline of 54%.

We’ve slung numbers here, I know. But the conclusion is simple. Whatever traders were doing in this small-cap, the Fed’s rate-hike ended it.  We think that’s good. But markets have been addicted for years to cheap credit, which includes borrowing shares for next to nothing, which shifts attention from long-term owning to short-term renting. That changed when the Fed bumped rates. And equites corrected.

There’s another lesson by extension.  What sets your stock’s price may be radically different than you think.  We’ve offered one example that shows short-term borrowing fueled persistent volatility trading masked by apparent long-term placidity. When interest rates crept up minutely, the strategy stopped working.

What’s your stock show?  Price-performance isn’t story alone, perhaps even over the long run, as we’ve just shown. There’s so much to see when measurements reflect current behavior (as ours do). Volatility is price-uncertainty that thanks to policies promoting short-term behavior is now concentrated intraday.  Sorting this out will take time. We won’t change seven fat years with a lean month. The good news is it’s all measurable.

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