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December 13, 2004

Volatility, Complacency, and Emerging Risks

John P. Hussman, Ph.D.
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Just a note - Thanks to the alert shareholders who forwarded a publication by a certain investment bank which misappropriated my research and presented it as original work. The line "All rights reserved and actively enforced" above means exactly that. I am very happy to write these weekly comments, post research papers, and allow reprints of various articles when they're properly attributed and linked to this site. But few things produce more immediate work for our attorneys than unauthorized, unattributed, public exploitation of this content.

The CBOE volatility index (VIX) measures the expected volatility that options traders build into call and put option prices on the S&P 500. It closed last week at just 12.66%. Historically, stocks have produced a long-term annualized return of about 10%, with a “standard deviation” of plus or minus 15% a year. That 15% is the historical “volatility” of annual returns. So if you think about stock returns as falling into a rough bell curve, the annual return on stocks would fall between –5% and +25% about two-thirds of the time. Of course, that 15% volatility is a historical average, and there has generally been a wide range of volatilities on a shorter-term basis, depending on market conditions (generally, poorly performing markets are actually accompanied by higher volatility, adding insult to injury from a return to risk standpoint).

Interestingly, the VIX is not a particularly reliable measure of past or future market volatility, but is instead closely related to investor psychology. Typically, options volatilities spike on market declines, when investors become very averse to risk and eager to hedge market volatility. In fact, the volatility priced into options in recent years has generally been much higher than 15%, routinely fluctuating in the 20-30% range. A frightening market decline can push the VIX toward 40% or more. In contrast, the VIX tends to decline during extended market advances, when investors become less eager to hedge against market risk. The recent figure of 12.66% is very low, but shouldn't be considered a lower bound – volatilities were often below 10% at various points in the 1980's and early 1990's.

Still, the current depressed level of the VIX strikes me as unusually complacent in the face of an overbought, overvalued market. Bullish sentiment (another contrary indicator) remains uncomfortably high, with the Investors Intelligence figures pushing to 60.8% bulls and just 21.7% bears last week. Meanwhile, corporate insiders are selling stock at a pace of over 6 shares sold for every share purchased. This figure is generally about 2-to-1, since insiders get most of their stock through stock and option grants rather than purchases, and can become periodically high when insiders are dumping low-priced garbage stocks as they eagerly did on rallies during the past bear market. Despite such influences, the ratio has moved up substantially in recent months, and is well confirmed by other measures of overextended sentiment. Investors Intelligence also notes an unusually large number of “buying climaxes” in individual stocks over the past two weeks (a buying climax occurs when a stock registers a new 52-week high during a particular week but closes down on the week). Industry groups are also very skewed toward overbought conditions.

Cyclically, I continue to view the economy as losing momentum following an induced jolt to demand through “helicopter money” (tax rebates and the peak of the refinancing boom). In contrast to most economic expansions, this one has fostered little emergence of new industries – a supply-side factor that usually characterizes sustained expansions. For that reason, as well as current account issues and other factors, I'm skeptical that the economy has many upside surprises left. Given that stocks have historically turned down about 6 months before the economy, I continue to be alert to economic signals in a variety of measures, most importantly interest rate and credit spreads, as well as the ISM figures.

All of that said, the stock market continues to have one clear (though not necessarily robust) positive: favorable market action overall. Yes, there is some initial turbulence in internal market action, but not yet enough to conclude that investors have abandoned their generally favorable attitude toward market risk. So even if stocks are currently establishing a cyclical peak, it doesn't follow that any sort of substantial decline must emerge in short order. Normally, market peaks are extended affairs, where internals begin breaking down despite still-strong indices. That sort of outcome is fortunate, because the increasing skittishness of investors can be observed even before the major indices move down substantially.

Of course, one can't rely too heavily on that typical outcome, especially when stocks are both overvalued and overbought. But it does imply that unfavorable fundamentals need not translate quickly into poor market performance.

For our part, the Strategic Growth Fund remains well hedged against downside risk, with index put options on the S&P 100 and Russell 2000 hedging the full dollar value of our stock holdings on the downside. However, unlike a full hedge, in which those puts would be matched with corresponding short call option positions, I have left some of those puts unmatched. That's another way of saying that the Fund retains a constructive position that I would expect to benefit moderately from market advances that might occur. Given the low volatility implied in option prices, the cost of that constructive exposure is also low, so I don't anticipate much cost in the way of time decay if the market moves sideways rather than advancing or declining substantially.

In short, the market continues to gather negatives in terms of market action, sentiment and economic momentum, but for now, the overall profile of market conditions remains constructive. Our preference is to accept a certain amount of market risk, but in a way that doesn't threaten unacceptable losses if conditions were to deteriorate abruptly. A market demonstrating favorable valuation and market action would, of course, be much preferred, but that will come later. At present, an overvalued market with moderately favorable market action is what we have, and we remain constructively positioned, if skeptical about further progress.

In bonds, the Market Climate is characterized by modestly unfavorable valuations and modestly unfavorable market action. Treasury inflation-protected securities remain my preference for the roughly 2.5 year duration currently held in the Strategic Total Return Fund. Both as a direct result of dollar depreciation and as an indirect result Fed tightenings (which historically have triggered short-term inflation by raising monetary velocity), inflation surprises are likely to remain on the upside in the months ahead.

New from Bill Hester: The Anxious Index


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