VIX Premium Forecasts Two More Years for Bear Market, Aligning With Financial Crisis Pattern

As readers probably know all too well, we are in the middle of another period of eroding confidence, frazzled nerves, and risk aversion. Equities have taken a tumble, with losses on the S&P today flirting with 4% after a 4.5% fall last week.

Bloomberg reports that traders are increasingly looking to buy longer term downside protection, suggesting that they believe the bear market has another two years to run:

Options investors are paying twice this decade’s average to protect against losses in U.S. stocks through 2011, signaling the bear market that already wiped out $10.4 trillion of equity value may last two more years.

“There’s a real panic in the markets, with some people wanting to buy long-term insurance at any price,” said Peter Sorrentino, who helps manage $16 billion, including $130 million in options at Huntington Asset Advisors Inc. in Cincinnati. “People have lost hope.”….

Two-year volatility dropped 14 percent from its record in November, compared with a 45 percent retreat in 30-day volatility. The difference shows that confidence in the market’s direction over one month has improved while concern about longer- term swings remains elevated, said Paul Britton, chief executive officer of New York-based Capstone Holdings Group, which specializes in volatility trading.

“The market is subdued now because we have enough morphine in our system that we won’t see the spikes we did in October and November,” Britton said. “The uncertainty comes when the medication runs out.”

What is interesting about this two-year time frame is that it puts the duration of the bear market in rough correspondence with what economists Carmen Reinhart and Kenneth Rogoff foresaw in a paper they presented to the AEA, comparing our current crisis to past financial crises. Key metrics:

1. Real housing price declines average over 35% over a six year period. Note in other crises, residential real estate was not necessarily a focus of the bubble. Even excluding Japan (which has suffered a 17 year housing price decline) the average is over 5 years.

2. Equity prices fall 55% over three and a half years.

3. GDP falls an average of 9% (read that twice)

4. Unemployment increases 7% over previous norms.

5. Government debt “explodes”, increasing an average of 86%, but the cause is typically not a banking industry recapitalization, but maintaining services in the face of collapsing tax revenues and countercyclical measure ex financial system measures.

Another crisis comparison was slightly less gloomy, finding that that equity bear markets associated with financial implosions typically last 10 quarters, with the real value of equities falling by half.

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  1. Thomas

    So who’s selling all this downside protection, I wonder? After all, somebody will have to bear the downside, if it does indeed materialize…

  2. Anonymous

    Betting money is that AIG, Citi & Goldman are selling the downside protection. They are too big to fail after all. :-)

  3. Mara

    “2. Equity prices fall 55% over three and a half years.”

    Seeing as how we’re 50% down from our 14,000 Dow level in Oct 2007, does that imply only a little more to go, or is that another 55% from today, which puts us closer to 3500 for the Dow. Some retracements could suggest something in the 4000 range if we can’t get up before the 10-count.

  4. Anonymous

    Where do the more reliable chartists now have the bottom? The recent 9000 + achievement at the time of the first stirings of the legend of Abraham Delano Obama was clearly a sucker punch with another major down wave, currently in progress, to go. A former trader, I’d venture a 6000 Dow based on instinct alone.

  5. Anonymous

    VIXing sounds a bit optimistic considering the taxpayer has to pay up for at least the next 20 years.

    Can’t believe the markets are reacting to AIG or even Citi news as if no one knew they are actually penny stocks. Are they even still indexed?

    Must be something else going on we haven’t heard about yet.

  6. Mr. Sparkle

    Arrggg… the VIX “predicting” something again.

    About the only thing the VIX tells us is approximately how many strikes on SPX are catching bids and the relative cost. It’s right there, in the CBOE white paper. So if you think that options traders are great predictors, than maybe the VIX has some insight.

    It does have a nice correlation to various moving averages of intraday SPX percentage range but that’s about it. I’d love to see someone numerically demonstrate the long-range predictive worth of the VIX.

    If the market started having 1% intraday ranges consistently, I bet we’d see the VIX drop even if the market continued on a downward trajectory.

  7. Anonymous

    Fibonacci retracement lines past 50% already bring 61.8% into view below 6,000. What bottoming formation is likely? An ‘L’

  8. Anonymous

    Don’t understand how VIX premium forecasts two years of “bear market”. Doesn’t it just imply it’s forecast two years of volatility, up *or* down?

    With put/call parity, doesn’t more expensive puts (due to demand) translate into more expensive calls?

  9. Anonymous

    OK as an equity derivative quant…long-term volatility is a whole ‘nother animal and the subject of huge academic debate AND IS NOT MEASURED BY THE VIX.

    The VIX is a weighted construct of the implied volatility of near term at the money and slightly out of the money.

    Over longer periods, most persons transacting options who know what they’re doing would model stochastic volatility, meaning you’d take into account the volatility (variance, or uncertainty) of your estimate of volatility … so for an atm strike, you’d expect long-term implied volatility to be higher than short-term.

    “the VIX tells us investors expect 2 years of bear market” has no intellectual content to it whatsoever, period.

    “the rise in open volume of long term put options” might tell you that, but it could also tell you we’re at the top of a bull market…

    please dont go nuts trying to understand the quote about the implicatino of the vix…its unintelligent

    perhaps “implied volatility of long-term options is much higher than usual and yet open interest is large” might indicate something…but it might now

    you cannot intelligently say anything about the view of investors from implied volatility of options premia as you have no idea what kind of book the investor has, is the investor speculating or hedging, or what

    no disrespect, Yves, i saw it on bloomberg too and cringed

    what you CAN tell is what investors perceive the future volatility to be, yes that you can tell (assuming investors are rational), but higher expected volatility doesnt necessarily correlate with bear or bull markets that i know of

  10. Anonymous


    to the person asking who is selling protection…

    if these are crossing on an exchange, its pretty likely that the other side is not a speculator but is a market maker either balancing a book or planning on dynamically hedging the exposure

    most options transactions are not two-sided, remember there is theoretically infinite liquidity, this isnt stock, so when you buy an option from someone or sell an option, the person on the other side is almost always going to be a broker who plans on reselling it and keeping the spread, or a market maker who will hedge it, and is indifferent to your view.

    of course if order flow is all in one direction, like massive order flow to buy puts, then there would be pressure on the underlying to go down in price because the counterparty thats hedging has to short the underlying to be able to hedge the risk of being short the put.

  11. Anonymous

    So how many trillions will it take to stablilze the derivative market if we can’t convince folks to kill investment banking strategies like this?

    Can you hear the printing presses? I can, inflation here we come.

    Its not a liquidity problem. Its not a debt problem. It is a GREED problem and until you fix that no one will want to do business with fascist America.

  12. brushes9

    The backlash against the 60’s “freedom ride” is fascist,.. and it has been a huge backlash.

    Click “brushes9” above to see the fruit of WPA flood control, in East Tennessee.

  13. Anonymous

    The key to understanding that study is that many of the examples cited are relatively small, isolated examples in a wider context of relative prosperity, so the economies can grow out to a larger whole that is in good health.

    What the study does not address is how difficult to recover when the dominant economies (and world economic system, namely the Anglo-Saxon based system) are all simultaneously in trouble.

    Likewise for the exaggerated role that housing and consumer spending in the US economy vs. the other examples mean there is much more downside than upside.

    Demographics are driving Americans to much smaller homes, changing the market mix as well and valuations.

    On that basis, the 55% average decline in stock valuations and 35% drop in real estate prices may be optimistic.


  14. tyaresun


    Have you had a chance to look at this post from Freakonomics?

    There’s a neat mathematical trick, by which we can use option prices to quantify the probability of the stock market falling by various amounts. Breeden and Litzenberger (1978) show that by comparing the prices of options at adjacent strike prices, you can calculate the approximate value of securities that would pay $1 if the underlying stock traded in a certain range on expiry day.

  15. Bob_in_MA

    Since Reinhart and Rogoff were looking at crises around the world, it's worth noting that in most of Europe and Asia (ex Japan) shares almost always have much lower P/Es than in the US, and pay much higher dividends.

    Tobin's Q is on average around .6 for the market. In Fall 2007 it was around 1. The 10-year cyclically adjusted P/E was 29.

    Napier found that the Q ratio reached .3 or below in severe bear markets and the cyclically adjusted P/E reached 7.

    That would put the S&P 500 at 400-450.

  16. Anonymous

    You should respect mathematics, but from a standing position, not a kneeling one.

    Investing in risky assets is an endeavor which is a zero sum game in the aggregate unless there is an increase in aggregate wealth.

    Assuming there exist metrics by which to value any of what I just said, that is, to value REAL wealth, then all the deviations about and around “rational” price behavior are both largely noisy and thus unpredictable and also the product of human behavior which is rarely rational.

    To attempt to “game” this as an investor is incredibly difficult.

    The more the noise and irrational or nonrational behavior, the harder it can be to compute, or rather ESTIMATE, real values.

    There is no way out of this, they don’t ring a bell when things will start to behave, and the only truth is that younger people have an edge over older people in time to grow wealth which is not, generally, offset by the shorter time frame of older people to need to live on their money.

    In the 1930s most people who retired at 65 from an average job could expect to live 3 to 5 years.

    Now it would be 20 years.

    There is no point here other than that all bets are off and its a shame to waste a lot of time trying to use ratiocination to compensate for what is inherently unknowable and now, for sure, has confidence intervals so wide as to make estimation useless.

    The only real strategy for most retail investors who have investible risk capital is to force themselves to average in no matter what.

    Last time I looked, an averaging in would have done respectably well over any 20 year period even starting in 1929. I’m pretty sure I remember that correctly.

    It’s a poor man’s arithmetic Asian option.

  17. Anonymous

    The Freakonomics article is incompetent. Among other things, there is no “most likely” scenario. From his graphs, the probability of the markets ending between 800 and 1000 is the same as the probability of it ending EITHER below, say, 600 or above 1200.

    Its the author of the article who’s incompetent, not the quants who wrote the paper he misunderstands.

  18. Anonymous

    This whole thing is about to become L shape japanese style recession.

    Businesses start to anticipate that type of recovery and they are not planning any big investment.

    Like I say before, if China and Asia recover first, liquidity and global investment will be sucked into asia like nobody’s business. (Think US high growth sucking Japanese liquidty during their L shape.)

    except Japan currency wasn’t global currency, so they can ride the wave to export their currency and lower Yen. Thus increasing export.

    But Yuan-Dollar is pegged, If China growth return to 9% while they loosen up currency flow restriction, they are going to explode. The rest of asia will go up in space along. (Free trade zone will start functioning by 2010)

  19. Mr. Sparkle

    @Anonymous – thank you for filling in a lot more detail than I had the patience to write. That the VIX continues to be cited as predictive of this or that continues to drive me a little bit insane each time.

  20. Justin

    Forecasts are useless for complex scenarios.:)

    However, market behavior is useful to gauge against outcome models where they very significantly against expected outcomes.

    I’m starting for the first time in 2 years to get interested in equity markets (probably April-June before we beat AAA corporate bond opportunity costs), and even with an L shaped recession/depression the outcomes are trending against the current pessimism. Still short everything, but watching for the capitulation in the (global) markets that changes the second derivative.

  21. bg

    Nobody knows how deep our troubles are. Most of us (including this uber bear) have been surprised to the downside.

    At 700 S&P 500, we are now at 12.7 PE (trailing 10 year method), which is below historical norms (14) but far above bear lows. We may see negative earnings for at least one quarter for the entire economy, which never happened in the Great Depression.

    That being said, even in crisis, 12.7 PE is low enough to average profitable investment 4% above inflation YOY. At 10 PE, this jumps to 8%.

    I have not jump in yet, but am not a shorter at these levels.

  22. Hu Flung Pu

    The Magazine Cover Indicator is starting to rear its head. I hear that Newsweek's current cover is something like, "Can Obama Talk Us Out of a Depression" or something like that.

    That's a little optimistic for me, as it suggests that Obama has any chance of doing so. When Newsweek's cover says, "How to Prepare for Armageddon," I'll know we've hit bottom.

    But we're making good progress. Personally, I think we'll bottom this year around 550/600 on the S&P. But I'll probably be wrong about that.

    (Previous famous magazine cover indicators include "The Death of Equities" in 1982, and "Are You Missing Out on the Housing Boom" from 2006.")

  23. john bougearel


    What is also interesting about Reinhardt and Rogoff’s timeline for this crisis running another two years is that it will then be much more closely aligned with the 2011-2012 Mayan calendar dates. No doubt, many of us can already feel a sort of spiritual revolution shaking out, a disrobing of the material spirit, a return to heart, a return to our place in community, a return to volunteerism within community and a return to prayer.

    Also, in case you missed it, the SP500 took out its Dec 17 1996 “irrational exuberance” low at 716 today, call it “rational despair.”

    It should be somewhat comforting from a contrarian perspective that traders are looking to hedge their portfolio’s out two years at this juncture. Too bad, it signals absolutely nothing at this juncture!

  24. Anonymous

    American purchasing power has been falling due to outsourcing, you were never able to afford the cheap goods to begin with.

    The problem was hidden by a blanket of credit.

    When you outsource, you create jobs overseas, but lose jobs at home.

    When jobs are lost at home, demand for the products produced overseas fall.

    So usually such a process would be too contradictory to function. But by giving easy access to credit, you effectively allow the process to function as debt is increased to buy the cheap goods which couldn’t be bought otherwise. Over time, people make less money but they get more credit, until their debt reaches a certain threshold where the debt cannot be repaid rapidly enough for the issuer of credit to survive, and the blanket is removed, revealing the hidden contradiction.


    There is no way out of this mess otherwise, the financial institutions will consume all the money thrown at them if the above issue is not fixed before the credit-supported re-ignition of the economy begins.

    If by then the problem has not been addressed above all other problems, you will experience a short-lived upward trend which will then be followed less than three years later by another recession that will come too soon to be addressed, and it will be the end of the game.

    Please repeat this for me wherever you go, I am a bit tired of repeating it but I’ve seen some progress.

  25. Jojo

    Chartology: Dow 6,000 On The Way?
    Posted By: Lee Brodie

    Unfortunately patterns in the S&P don't translate into good news. Yamada sees a clear 10 year double-top and suggests we probably have further to fall.

    "Now that the 2002 lows have given way we have further to go," she says. "The first targets are 6,000 in the Dow and 600 in the S&P and the second target, I hate to say it, could be 4,000 and 400."

    To support her thesis she points to trends that happened immediately following the Crash of 1929. Wealth destruction didn't actually occur at the crash. It happened after a bounce in 1930 and lasted well into 1933.

    If you're looking for a survival strategy Yamada says it's important to be holding cash. "And if you get into this market make sure it's with a trailing stop."



  26. Edwardo

    A 55% percent hair cut for equities? That’s laughable, since we’ve already exceeded that. Yes, this bear will probably last till late next year or early ’11. In the meantime, we are a week or three from a meaningful trading low.

    When this bear market gets done, the SPX will have lose AT LEAST 80% of its value. In Elliot Wave parlance this bear market is of Grand Super Cycle Degree, one degree higher than the bear market that ushered in The Great Depression. As a result all the numbers proffered above are well below what they should be.

  27. d4winds

    Anonymous, March 2, 2009 4:27 PM,
    Well done.

    The Breeden and Litzenberger probabilities are not market forecasts of the events you describe. They are implict, embedded market prices for the events. A spike in one of them doesn’t mean the market thinks it’s more likely, only that it wants a greater risk premium for making the bet.

  28. eh

    3. GDP falls an average of 9% (read that twice)

    Read what GDP is actually composed of — how they calculate it. Then it’s not so hard to believe.

  29. raytayzmd

    …I agree with “Mr. Sparkle”‘s response…what is it with people and trying to predict the future?…no one nor any indicator can reliably predict the future — period!…the best anyone can do is to manage their CURRENT situation in the present…and just as annoying id the reference to the Reinhardt/Rogoff paper…the ONLY thing economists are good at is providing ad hoc analysis of things that happened IN THE PAST…their score at predicting future events is — on average – ZERO…that’s WHY they work for piddling salaries at colleges and universities…

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