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January 31, 2005

Cheap Vol

John P. Hussman, Ph.D.
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I've noted in recent months that option volatility, as measured by the CBOE volatility index (VIX), remains very low relative to recent years. In general, peaks in the stock market tend to be accompanied by low volatility, but low volatility in itself does not necessarily imply a market peak. A more useful danger signal occurs when implied volatility is relatively low and then breaks higher. On that basis, an increase in the CBOE volatility index past about 14-15% would an element of concern, because it would mark a shift by investors from complacency to risk aversion. We haven't seen that yet.

In part, the relatively low volatility implied into option prices can be explained by the fact that market volatility itself has declined substantially since early 2003. As the chart below suggests, option volatility generally runs somewhat higher than actual price volatility.

[Geeks note: This is not necessarily inefficient. As a technical matter, equal volatilities would fairly price options held to expiration, but would also generally allow a profitable “gamma scalping” strategy (where traders raise strike prices after rallies and lower them after declines) provided that the trades were not made continuously with each move in the market. Even periodic gamma scalping can allow an option position to be carried with substantially less time decay than a static position might experience. This is an important practice in my day-to-day management of the Strategic Growth Fund.]

As the chart makes clear, option volatility has declined to the point where it is very close to the actual volatility of stock prices. This creates important opportunities:

In a Market Climate characterized by unusually high valuations but still favorable market action, we have a situation where the market continues to demonstrate some speculative support, but where deterioration in investors' willingness to speculate could lead to a potentially deep follow-through to the downside. For this reason, risk management considerations make it imperative to hedge against that potential downside risk, even while expected return considerations encourage a modestly positive exposure to market fluctuations overall. There are two ways to achieve this. One would be to hedge a large but incomplete portion of our stock holdings with pure offsetting short sales in the major indices. The other is to hedge with put options only, retaining our potential exposure to whatever speculative market advance might emerge given still favorable market action.

The deciding factor between those choices is the level of option premiums. Very high implied option volatility would make a “directional” put option position potentially costly in terms of time decay, and we would require very large movements in the market in order to manage the position enough to offset that decay. In contrast, low implied option volatility makes the directional hedge much more reasonable. Not surprisingly, the Strategic Growth Fund continues to hold a substantial directional hedge here, centered near current market levels. About 30% of our hedge represents “pure” short sales on the S&P 100 and Russell 2000 indices (matched long put/short call combinations). The remainder of our hedge is put option-only coverage.

Simply, this means that a substantial market decline from these levels would move our put options into-the-money, resulting in a smaller and smaller sensitivity to market fluctuations as the market declines. In contrast, a substantial market advance from these levels would move our put option coverage out-of-the-money, resulting in a smaller and smaller drag on the performance of the Fund as the market advances. Of course, the cost of that asymmetry or “curvature” is the time premium that we pay for the options, which at present remains quite low on the basis of implied volatility.

A low volatility, sideways market would extract the greatest cost from this position, as it would limit our ability to offset time decay by changing strike prices and expirations over time. At present, the Strategic Growth Fund continues to have a modest 1.5% of assets at risk of time decay. In other words, the Fund's position can be viewed either as fully hedged, plus 1.5% of assets in index call options, or alternatively, hedged with put options only. The Fund would benefit most from a substantial upward move in the market, particularly one that was sustained over several weeks. In the event of a substantial and sustained market decline, the performance of the Fund would be as much as 1.5% lower than it would be if the Fund was fully hedged here.

Market Climate

As of last week, the Market Climate in stocks continued to be characterized by unusually unfavorable valuations and still moderately favorable market action. Despite the relatively “sick” look of the major indices, we continue to observe too much internal resilience to conclude that investors have shifted to a skittish view of market risk. A moderate further market decline, if accompanied by weak breadth, a substantial expansion in the number of stocks registering new lows, or other internal weakness, would probably be enough to shift us to a fully hedged position, but for now, the market retains the benefit of the doubt, and given the continued potential for market resilience, I am comfortable placing a small percentage of assets at risk on the basis of this evidence.

My opinion (which we don't trade on and neither should you) is that the stock market is still in the process of establishing a peak of the corrective advance that began in early 2003. In my view, stocks probably remain in what could be considered a “secular bear market” (a series of multi-year market cycles – bear markets followed by bull markets – in which the bear declines establish successively lower and more normal levels of valuation). While that view is helpful in framing the “big picture” for risk management purposes, particularly at current valuations, it is not particularly useful in setting shorter term investment exposure (and is of no use at all in forecasting short-term market movements, which we don't even attempt).

Despite that opinion, we have a stock market that, as yet, has not produced enough deterioration in market action to warrant a fully defensive position. While defense against the potential for large market losses is an essential aspect of risk management given current valuations, and market action deserves continued close attention for any evidence of abrupt deterioration, return considerations continue to warrant a positive exposure to market fluctuations for now.

In bonds, the Market Climate remained characterized last week by moderately unfavorable valuations and moderately unfavorable market action. We continue to hold a relatively short 2-year duration in the Strategic Total Return Fund (meaning that a 100 basis point change in interest rates would be expected to impact Fund value by about 2% on the basis of bond price fluctuations). Most of this duration remains in relatively limited duration Treasury Inflation Protected Securities. The Fund continues to hold about 19% of assets in precious metals shares, for which our Market Climate measures remain strongly favorable - particularly with the U.S. dollar no longer oversold and still vulnerable to weakness based on inflation pressures, potential economic sluggishness, and current account imbalances.


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