VIX Signaling Equity Downdraft in September

It was mathematician Benoit Mandelbrot who first discovered in 1962, by crunching 100 years of cotton trading data, that markets have “fat tails” or more extreme risks than the standard models predict. A less oft cited finding of Mandelbrot’s was that markets have memory, in colloquial terms. Calm days tend to be followed by calm days, volatile ones by volatile ones. That again is not the pattern predicted by standard theories, which hold that day to day changes are random.

But did Mandelbrot think that markets have memory in a more literal fashion? September and October are usually the worst months of the year, and last September will remain in the memory of anyone who had reason to be interested in matters financial (and even those who weren’t normally took interest). The VIX appears is anticipating a bit of a re-run of last year’s downdraft, at least as far as equities are concerned.

From Bloomberg:

Options traders are increasing bets that the steepest rally in the Standard & Poor’s 500 Index since the 1930s won’t survive September…

Traders are betting the VIX, a gauge of expected stock swings, will increase 13 percent in the next five week….That’s the biggest spread since August 2008, right before the S&P 500 suffered the steepest two-month plunge in 21 years. The indexes have moved in the opposite direction 81 percent of the time over the past five years…

“It’s a danger sign,” said Ronald Egalka, a 36-year options trader who oversees $8 billion as chief executive officer of Rampart Investment Management in Boston. “People expect volatility to pick up in the future, and that implies that there’s going to be a downward movement in the market.”…

The gauge plunged 9.1 percent last September after New York-based Lehman Brothers Holdings Inc. collapsed. The biggest drop occurred in September 1931 during the Great Depression, when the S&P 500 tumbled 30 percent. February is the only other month when stocks fell on average since 1928, losing 0.3 percent…

The index has averaged 20.22 over its 19-year history and surpassed 50 for the first time in October after Lehman filed for the biggest U.S. bankruptcy. Frozen credit markets and bank losses approaching $1 trillion tied to subprime loans pushed the measure to a record 89.53 on Oct. 24. …

The current reading indicates a 68 percent likelihood the S&P 500 will fluctuate as much as 7.2 percent in the next 30 days, according to data compiled by Bloomberg.

“VIX futures are telling you that investors are willing to pay a premium for protection,” said David Palmer, who helps oversee $300 million as volatility portfolio manager at Hudson Bay Capital Management LLC, a New York-based hedge fund that returned 11 percent last year, according to Absolute Return magazine. “People expect some sort of a break in the market.”….

Options strategists saw the same upward-sloping curve last August, before the S&P 500 tumbled 9.1 percent in September and 17 percent in October. VIX futures two months from expiration were 4.11 points higher than the VIX on Aug. 22, when the index slumped to an 11-week low of 18.81…

Volatility may be increasing for reasons unrelated to stock prices, according to Macro Risk Advisors LLC, a New York-based options brokerage. Traders who sold bullish options when the rally began on expectations the advance would fizzle may be buying them back now, Dean Curnutt, the firm’s president, wrote in a note to clients. That demand could be artificially boosting the VIX.

U.S. companies are also beating analysts’ earnings estimates at an almost record rate, making investors more bullish, according to Rob Morgan, who helps oversee $6 billion as market strategist at Clermont Wealth Strategies in Lancaster, Pennsylvania….

Investors still hold more than $3.6 trillion of their assets in money-market funds, equal to about 30 percent of the total market capitalization of U.S. companies, according to data compiled by the Washington-based Investment Company Institute and Bloomberg.,,,

Paul Tudor Jones, the hedge fund manager whose $8.9 billion Tudor BVI fund gained 10 percent this year through July, said he expects that global stocks may “pause in September” on slower Chinese economic growth. The advance since March is a “bear- market rally,” Jones wrote in a report to clients last week. “We are not inclined to aggressively chase the market here.”…

“There is a real danger this is going to be a double dip and that after six months or so we’ll have some more bad news,” Feldstein, the former head of the National Bureau of Economic Research, said on Bloomberg Television last month. “We could slide down again in the fourth quarter.”…

“There’s always a real risk that a rally is going to be tested,” said Stephen Wood, New York-based chief market strategist for North America at Russell Investments, which had $151.8 billion in assets under management as of June 30. “Investors are thinking that giving up some upside to hedge the downside is a very reasonable investment profile.”

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  1. eh

    I've noticed that, for some of the symbols I track, call prices for e.g. September do not really reflect what you'd expect if this rally was thought to be sustainable.

    While the market no longer has that coiled spring feel — as if it was waiting for just about any 'less bad' news, no matter how laughable, to jump higher — I am extremely wary.

  2. PB

    Mainstream media meme:

    Market goes up? Fundamentals are getting better.

    Market goes down? Obviously, it's just some traders taking profits while the fundamentals continue to get better.

    Rationality is the new irrationality.

  3. rob

    There used to be good historical reason for markets crashing in the Fall (or I should say this theory makes sense to me). Farmers would borrow heavily in the Spring for planting. If the harvest was poor, lenders would panic in Sept/Oct.

    Agriculture is now a much smaller portion of the economy, so I don't really know why this pattern would still occur – that is unless market participants react in the Fall because they expect other market players to react at the same time. If so, this "remembered pattern" is quite an amusing example of the simulacra economy.

  4. ndk

    There are very good reasons for momentum-based trading in the current environment.

    If we do indeed still sit on the precipice of a debt-deflationary spiral, there is still a pressing need to get liquidity into the economy. One of the readiest contact points for monetary policy with the real economy is through the asset markets.

    As long as asset markets are rising, it implies greater creation of cash and a greater likelihood that we reach escape velocity from the trap, leading to a real inflationary period. That means cash is trash, and securities/real assets should be bought. Rinse, repeat.

    If instead September marks an end to the recovery in the asset markets, and underlying economic processes begin to revert, we can expect to see the same compounding forces working in the other direction. Falling asset prices exacerbate debt problems, and balance sheet issues will become paramount again.

    The reason the stock market is such an excellent forward indicator is that, in many cases, it creates its own reality. I'm out of it for now, having capitulated on shorts and caught some of the upward rally following my last exchange with Andrew Bissell. I'm not willing to risk capital either way here. If the ^VIX and declining volume are any indication, others feel similarly…

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