Extreme Volatility

Like our prior set of charts, the following VIX graph from Birinyi Associates discusses a measure of sentiment hitting an extreme measure — they call it "extreme volatility."

How is that defined? Anytime the VIX doubles over 50 days:

"Over the last 50 trading days the
CBOE Volatility Index (VIX) is up over 100% which is an occurrence we
have seen in only five other periods…The chart of the S&P 500 highlights the first day of
each of the prior periods where this occurred. Each of these prior
occurrences have coincided with market weakness, which was then
followed by positive returns."

Let’s look at their chart, which I annotated below:

The first two of these 5 examples of extreme volatility may have been followed by positive returns, but they didn’t lead to a significant snapback anytime soon (left side of graph, un-numbered):

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Vix_spx

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However, the 3 most recent prior examples of extreme volatility did, and I have annotated them with numbers 1, 2 and 3 (This week’s example is marked "?").

Here’s how they break down:

Point 1: August 1998 Sell off (due to LTCM blow up) led to much more upside

Point 2:  post 9/11 Sell off led to a 40% plus Nasdaq rally, which ultimately failed and made new lows

Point 3: Late 2002 lows, led to a small pop, and a successful retest pre-Iraq Invasion

Point ? is this week.

Note that the prior 3 VIX events all had a response from the Fed of massively increasing liquidity: Rates were lowered, money supplies were increased. However, at present, liquidity is being removed from the system — not added. That is consistent with our expectations for a small bounce 3-6 weeks,  and not the beginning of a brand new cycle.

Short term, this VIX move looks parallel to three most recent versions; Longer term, however, I suspect it will have less legs than the 1998 or 2002/03 versions.

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For some background on this, look at our December 2005 discussion Death of Volatility, and the more recent January 2006 calls to "Buy Volatility."

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