Why so tricky, Vicky VIX?

by Ashok Talukdar CFA | November 20, 2008

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Anyone who doubts the power exercised by select groups of investors over America’s stockmarket should witness today’s precise intraday re-visitation of the S&P500’s closing low from the bear market of 2002.  After the tortuous attempts at bottom-forming of October 2008, the 776.76 level was matched precisely today (Thursday 20th November 2008) to exactly two decimal places before the market turned around and rose again (as it still seems to be doing at this time of writing).  However unlike last month’s blind panic, the symptoms surrounding this latest equity market decline seem more restrained.  Gold appears to be holding its own and even the VIX (though naturally higher) has yet to spike to the intraday 89% reached at the market open of 24th October 2008.  The latter metric has been around for 18+ years and with investors around the world now scrutinising her every move, term shape and momentum measure for clues about what happens next for equities, perhaps it’s worth actually taking a step back and taking a broader look at fickle Victoria VIX.  Because she‘s changed.

Often described to the public as a “fear” index by the mainstream media, the VIX is seldom compared to other directly observable expressions of fear or risk aversion, despite now having its own tradable futures and options and a meaningful statistical history.  So it might reward us to examine a couple of other observable risk aversion measures to help expand our expectations of what the VIX might be capable of during the current market downturn.

One (somewhat sanguine) example of the behaviour of an observable fear index is the spread of 30yr Petronas bonds over US Treasuries during the late 1990s Asian meltdown.  Even with oil near $10/barrel there was never much doubt that this state-backed Malaysian entity was capable of repaying its debts.  After all, it dug the stuff out of the ground in a rapidly industrialising region and sold it in dollars on the open market.  The environment that caused a buyers’ strike in Petronas debt along with all other Asian credit is not dissimilar to what western credit is facing during our own de-leveraging phase now.  Knee-jerk policymaking, desperate central banking, the prospect of government intervention and sequestration, refinancing nightmares for over-levered businesses, competitive currency devaluations and even the threat of capital controls were and are common to both episodes.  For their part the western rating agencies sent Petronas from A- to BBB- towards the end of the Asian meltdown but although it never lost its investment grade status during the whole nasty episode and the region soon began to export its way out of trouble (sadly not an option so readily available to the west today), what became clear was the new geometric behaviour of credit spreads such as Petronas during the panic.  The following Bloomberg chart of the Petronas 2026 dollar bonds shows that what began as an imprudently tight spread of around 100bps p.a. over US Treasuries shot up but paused briefly near +200bps, then +400bps, then +800bps before finally reaching almost +1100bps over Treasuries:

 
Hence, this observable “fear” index broadly doubled in size three times before its final blow-out and recovery.  These geometric spikes were new and markedly different to the smooth serial arithmetic movements of 50bps in and out until then.  It was a behaviour born of the positive feedback between panic and forced selling, no matter what fundamentals remained in place. Likewise, it is such geometric spikes which cause the sharp discontinuities that badly undermine normal portfolio construction techniques intended for more sedate, arithmetic spread movements.

Another (more sobering) example of the behaviour of an observable fear index is the 5yr Lehman Bros CDS price before its failure this year.  The first months of the credit crunch saw the imprudently low +50bps p.a. spike up and find a resting place either side of +100bps, thence +200bps (with very sharp asymmetric overshoots), then +400bps and rapid progress toward +800bps prior to which Lehman died:

Hence, this observable “fear” index was well on its way to broadly having doubled in size four times before oblivion. 

So what of the VIX? 

Worryingly, she is no longer dancing in a smooth and arithmetic way but suddenly went geometric on us all this autumn.  Probably as a result of the huge amounts of highly geared attention it is now receiving during our present de-leveraging crisis, the VIX range of 10%-20% that was maintained during the good times and the 20-40% range that was reached during the de-leveraging episode between the Asian bust and the early 2000s, may now have led to a 40%-80% range:

So if VIX as an observable “fear” indicator has broadly doubled in size twice already, what is to stop it doubling again to a range of 80%-160%?  This would be our contemporary equivalent of what happened to Petronas between 1997 to1999.  Hopefully it won’t turn into our equivalent of the Lehman CDS price.

The fallout from VIX going geometric this October is still to fully reveal itself – specifically from managers who thought (with much justification) that they were safe to sell volatility-related strategies once VIX reached 40%, only to then see it double.  The circumstances under which VIX leaps to the 80%-160% range will undoubtedly feel like the end of the World for reasons that inevitably we cannot foresee.  Perhaps a custodian will fail or Iran will finally test a nuke or the new American President will decide that he’d prefer another job.

VIX reaching 120% and then bouncing around 40% either side of it will not mean our markets are broken - merely that Victoria has become intolerably high maintenance for a while.  And the more we let our 18 year old get on with this destructive phase without well-intentioned bailouts or finger-wagging interference, the quicker she is likely to grow out of it.

 

Copyright © 2008 Ashok Talukdar CFA
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Ashok Talukdar CFA | London, England | Email

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