What Was That Famous Line From JP Morgan ?.....

When asked for his forecast for the stock prices his reply was "they will fluctuate".
Well I would add a bit to that forecast for the near future....they will fluctuate alot. Faced with this prospect and the ability for retail investors to buy volatility in one instrument (vxx and vzz) I would see that as a far more logical move than trying to pick bottoms or tops.Mr. Market is giving at this point that the beginning of summer will be quite interesting for investors.


From the WSJ:

The sudden downdraft in world markets demonstrates that, despite more than a year of stock recovery, investor confidence in the wake of the financial crisis remains uncommonly fragile.
Until a few weeks ago, the market seemed to be returning to a pre-crisis norm. Commonly watched gauges of investor anxiety had tumbled to levels seen before the crisis. Corporate profits and economic growth proved surprisingly resilient, quieting investor doubts about the rally's staying power.

But Europe's difficulties in resolving its debt problems, the "flash crash" of May 6 and the national debate over the proper role of the nation's top banks have again put investors on edge, reawakening the fear and anxiety of the financial crisis that were lurking just below the surface. The sudden surge in gauges like the Chicago Board Options Exchange's volatility index, a commonly used barometer of investor anxiety, and the sharp correction of major stock indexes showed just how nervous investors are.
That suggests that more volatility is in store and future stock gains could be harder to come by.

T

Another strong sign of investor anxiety lately is their return to options to hedge risk. In times of increased fear, investors buy put options, permitting them to sell shares at a prearranged price, which helps protect them from losses in the event that prices suddenly fall.
The CBOE's volatility index, or VIX, is a measure of options demand. On April 20, with stocks and investor confidence rising, the VIX finished the day at 15.73, down where it was before the 2008 financial crisis began in earnest.

The Big Guys Are Still Fighting The Fiduciary Standard

I have written several times about the prospect of including the fiduciary standard as a standard for stockbrokers and insurance agents. Despite the senate passing the new law on financial services regulation the issue is still open as the House and Senate versions treat the issue differently. Kathy Kristof of the la times writes:

Two similar versions of financial reform — the one approved by the Senate on Thursday and the one passed by the House in December — must now be reconciled to create a final law.  ...

Now there's a last-ditch battle to determine whether the reform package ultimately will require all financial advisors to be fiduciaries, or trustees for their clients, as the House bill requires.....

When the Senate voted to cut off debate on financial reform Thursday, tough language demanding that all advisors be held to a high standard of trust was sidelined for a provision that would just have securities regulators "study" the issue. That would leave brokers and insurance agents able to continue with business as usual. 

Most individuals aren't aware of this issue and dont realize that registered investment advisors (like me) are held to fiduciary standards brokers and insurance agents aren't. As the same article notes;

This fiduciary provision is simple, says Bob Webster, a spokesman for the North American Securities Administrators Assn. It demands that financial advisors — regardless of whether they call themselves "wealth planners" or "investment specialists" — put their clients' interests ahead of their own.
If they have a conflict of interest, they have to disclose it. If they think an investment you own or a product they're selling isn't good for you, they have to say so.
You thought that was already true? Think again,.....

Kristof goes through a few myths used by the industry against the fiduciary standards and debunks them. Here's one

Myth: Imposing a fiduciary standard on all financial advisors would deny investors access to valued products and services.
Reality: Investment professionals could sell exactly the same products they sell now, but they would not be able to tell you that they were offering impartial advice when they were simply trying to sell a product that would earn them a commission......

Brokers and insurance agents take great pains to obscure the difference between advisors who must look out for your best interests and those who don't have to. That leaves investors learning the lesson of who they can trust too late — when they're already stuck with a high-cost, low-value product that enriched the advisor rather than the investor. It's time to stop calling salesmen advisors.

Why Does The Story Always Seem The Same ? (Hedge Funds Division)

I cannot count the number of times I have read about advisors who recommend the use of hedge funds in a portfolio because they are "uncorrelated" with the overall market and "because of their ability to go short can make money in a down market".

But it seems like the story is always like this one (below). With a few exceptions of course the overwhelming evidence is that hedge funds are highly correlated to overall market trends. In fact it seems that their years of outperformance vs the market are in years when the market goes up and vice versa. And that shouldnt really be surprising the funds specialize in taking higher risks than the market through leverage and concentrated bets on the riskiest parts of the market. Thus when the market hits a speed bump their positions get  hit hard.

Three clear conclusions:

1. Hedge funds are not an asset class they are a bet on an individual manager's ability to generate alpha

2. True alpha= excess returns on a risk adjusted basis is very very hard to generate on a consistent basis. Those hedgies that generate excess returns are largely not generating alpha they are taking additional risk relative to the market with leverage and concentrations in higly volatile sectors. Add in the lack of liquidity vs investments like listed etfs and the case for hedge funds diminishes future. A true evaluation must adjusted for both risk and lower liquidity.

3. Just when an investor needs diversification most....during market crises hedge funds provide little of it.


from the FT:

Hedge funds hit by May volatility

By Sam Jones, Hedge Funds Correspondent
Published: May 17 2010 03:00 | Last updated: May 17 2010 03:00

Some of the world's biggest hedge funds have suffered significant losses this month after high levels of volatility across markets and the shortlived stock market plunge in New York combined to wipe billions from portfolios.
Losses in the first week of May alone erased all gains made so far this year for some managers, according to investors who spoke to the Financial Times.
Large losses in a single week are not unusual for hedge funds, which typically aim to outperform markets and cut volatility, but those this month have come as a stark reminder to many of the continuing uncertainty over the economic recovery.

Now That We Understand A Bit More About VIX, VIX Futures VXX and VXZ (from the last post) How Best to Use VXX and VXN

Whar are the implications for the market outlook of the analysis in the previous blog for the "real world" of the markets:

It seems the market anticipates near term volatility no doubt on the downside in particular.

As for those watching the vix, vxx and vxz:

The period since the introduction of the vxx have no doubt been extremely painful and frustrating for those that held it. Since the vxx represents the near term future and the contango was very large the vxx suffered large losses due to the cost of rolling futures contracts as they expired. Hence the sharp decline in the vxx far more extreme than the cash index. As for the vxz the losses were less extreme becuase of the less extreme curve between the mid date futures it represents and the less frequent roll trades.

But judging by much analysis I can have seen people have thrown in the towel on the vxx based on the short time period since the instrument has started trading. As seen in the table above as the vix increases to extreme levels the curve of term strucutre fkips, In other words the holder of the vix gets an extra boost in return just when he wants the hedge to be most effective.

Effectively the time decay of option premia hurt the vxx far more than the vxz. And the vxx is more sensitive to changes in the vix than is the vxz.

This differential means that the vxx is far more sensitive to changes in the vix than the vxz. The "hedge ratio" ration of price change in the etn relative to change in the far higher for vxx to vxz.

As volatility and the vix increased massively over recent trading days this was readily apparent the long suffering vxx holder saw their positions increase a multiple of the vxz and a large multiple of the actual volatility in the s+p 500 and by extension the global equity markets. Those looking for a 1:1 movement between the vix and one of the etns were disappointed but they were looking for the wrong result. The etns are linked to the future not to the vix which is an index and cannot be traded.

The correct way to look at these instruments is either as a hedge of a long equity position or a trade.  Since volatility is more extremen on the downside, the vxx or vxz position would offset those losses  And the instruments performed extremely well  the vxx for instance on friday moved  the percentage move in the sp 500, the vxz moved . Furthermore with the flip in the futures curve from contango to backwardazation the vxx will likely suffer little or no loss when rolling contracts/

So what is the bottom line for use of the vxx and vxz:

They should be viewed as a way to offset the actual volatility of the S+P 500 either as a trade or a hedge.

Traders should look to the vxx which has a higher leverage to the underlying moves but a slow market will translated to a far steeper decline in value. The volatility of volatiliy is far higher for the vxx. But the leverage of the vxx is quite large recently it moved 4-5x the move in the sp 500

Those looking for a longer term hedging vehicle should look to the vxz. Recently it moved around 2x the move in the sp 500.

Using the above numbers one could argue that a 20=25% position in vxx would offset all of the loss on a stock portfolio during turbulent times. For vxz it would be closer to 50%.

This instrument has an  added benefti. In a turbulent down market we have observed two things:

volatility spikes increasing the leverage of these instruments
Among equtiies diversification becomes weaker and "the only thing that goes up in a down market is correlation". So these instruments provide a hedge (although of course of not identical efficacy ) of the non US parts of an equity portfolio as well as the small cap US despite the fact the sp 500 is large cap US stocks


Here are 3 mos graphs of the vxx(top) and vxz note how painful the futures roll has been for longer term holders of the vxx while recently the market has been more favorable to vxx over vxz holders.

So what would be the optinal strategy for those that want to hold a black swan hedge in their portfolio ? A longer term position in the vxz an addition of vxx position or a partial swap from vxz to vxx in anticipation of higher volatility in the market and a reversal of the position during a time of market stability. Of course the likelihood of getting that timing right is as great as the likelihood of timing any other market. But a mix of a larger position in vxz combined with a smaller proportion of vxx probably the best approach with the caveat to avoid the vxx completely when the futures mkt is in deep contango.

The VIX Term Structure and What it Says About Future Volatilty...and That Black Swan Hedge

Judging by the CBOE website there is considerable interest in the term structure of vix futures measured as the difference between near term and further out futures on the vix and also the realtionship of futures to the cash vix. This can be a premium (contango) or discount backwardization, In fact there seems to be dispute even as to how to interpret that curve as the market predictor of future volatility.

A presentation on this subject on the cboe website they present a contrasting view of option expert and author Lawrence McMillan who sees an uupward sloping curve as a portent of high future volatility and that of "traders" who hold the opposite view. Based on my observation of market data, my experience in the currency options market and my inclination to follow the money rather than the analysis on paper I go with the view of the traders.

My reasoning is as follows. First off it is important to know that the vix itself is not a commodity that can be traded it is really what I would call a "plug number" or the calculated implied volatilty of the near dated S+P options. Without getting into a detailed explanation of the calculation (you can find that here) suffice it to say that if one knows the price of the option, the strike price of the option, the days to maturity and short term interest rates one can calculate the "implied volatility of options". Since professional market makers in options can (with limitations change the directional exposure of any option through reversals and conversions they are trading implied volatility).

The enemy of an option holdesr is a dead market. If the market is devoid of volatility, the option holder's positions will not  increase in value and the time decay of the options will be a slow bleed. Conversely the trader holding a short option position makes a bit of profit each day through time decay  in a dead market. Add to this the lack of  demand from directional option players in a dead market.  Since the time decay of short dated options is higher than that of long dated options the selling is more pronounced in the short dated options this is reflected in the vix and in the short dated futures hence contango  (short dated futures at a discount to longer dated).

When the market heats up two things happern those with short options scramble to reduce their risk of their short options moving into the money.  If the expectation is for a short term boost in volatility the first move is to buy the cheapest options  that are most sensitive to movements of the underlying (pushing the vix, a calculated number based on near term options) and to push near term futures at a premium to the longer term futures =  backwardization in the futures.

The cboe has some data on the curve  based on the differential between the cash vix and the futures, the direction of that differential is usually the same as the shape futures curve as well as the spx itself. Sharp downmoves in the lead to the vix trading at a premium to the futures (and generally the futures curve going into backwardation. The chart of the fall 2008 market collapse period can be compared to the middle of 2009 and the mkt recovery. And since extremes of volatility coincide with sharp market declines it is not surprising to see the pattern in this chart from fall of 2008 of vix cash vx futures.


The cboe website also has data for  for the relationship between the cash vix the futures and the futures curve . Here is a great table. The higher the vix the deeper the backwardation and vice verssa. Not surprisingly traders play this spread buying the near date and selling the further date in anticipation of high volatility and reversing the position when the outlook changes.

Average Realized VIX Spreads 1990-2003

Spot VIX	Spot to 1 Month	1 to 2 months	2 to 3 months
15 to 20	4.02	1.64	1.74
20 to 25	0.92	0.85	0.25
25 to 30	-0.96	-1.24	-0.48
30 to 35	-3.23	-2.88	-1.57
35 to 40	-4.63	-2.94	-2.77
40 to 45	-9.95	-4.11	-2.33

The pattern was born out in the recent market .Here are 1 to 2 month spreads around the flash crash date (below). The next post will comment on how to use this information in hedging and trading..

29-Apr	1.99
7-May	-6.05
14-May	0.71

I Think We Have Seen This Movie Before

 Although we may not be there yet, according to this analysis  things are starting to look very familiar: Deja Vu all over again ?

Large Market Selloff
Sellloff instensified by leveraged investments, computerized trading and liquidation of hedge funds
All "risk assets" move down simultaneously: US across the board, commodities, developed and emerging market stocks and bonds
In the fixed income area a flight to quality with a large increase in spreads over treasuries for investment grade and high yield corporate bonds
Actual volaitility (VIX) and vix futures move up to extreme levels

The rational response for investors (as opposed to traders)

During the early phases purchase volatility through futures options, vxx or vxz etns. Resist temptation to trade the move by selling off long term positions, shorting or attempting to pick bottoms in commodities or equities.

During later stages monitor fixed income spreads. In 2008 high yield bonds reached a spread of 2000 basis points over treasuries vs a  long term average closer to 500 bp. High grade corporates exceeded 500 bp over treasury when their long term average is well below 100 bp.

These levels are clearly "overshoots" from fair value and at those extreme levels the risk/return in favor of high historic yields and capital gains are skewed in favor of the buyer. Since the default rate factored into such yields is way in excess of a rational expectation of actual defaults, purchasing bonds at such levels is far less risky than trying to pick a bottom for stocks. The lower risk move would be to make purchases as spreads begin to narrow rather than trying to pick an absolute top. Long term investors are likely to be awarded for their discipline and patience in making bond purchases in such market conditions,

Last time this movie played here is what high yield spreads did as stocks tumbled (hats off to bespoke investments)

Pardon Me If I am a Bit Provincial Today

Pretty Impressive Achievements for a tiny country of 6 million:

Israel etf (symbol eis)  picture above since inception. The market is one of the first if not the first to recover to pre Lehman collapse levels


WSJ

Israeli Firms Gird for Their Emergence

By CHARLES LEVINSON

TEL AVIV—Israeli companies are scrambling to compete with the big boys for international investment dollars, ahead of the reclassification of Israel later this month from emerging to developed market by the influential indexing firm MSCI Inc.


NYT:

Israel Will Join Economic Group of Developed Nations

By ETHAN BRONNER

Published: May 10, 2010

I am a bit involved in investment services in Israel more info here

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