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Volatility Is Dangerous for the Markets

A suggested way to look at volatility is through the ratio of implied volatility to historical (realized) volatility. The next chart shows the level of the S&P 500 index on the left scale and the ratio of VIX to the rolling 12 months of volatility on the right scale (the ratio of IV/HV or Implied Volatility divided by the Historic Volatility).

I can discern three periods here: From 1999 to 2002, the market went down, while the ratio stayed in the same range; then from 2002 to 2007, the market is going up, while the ratio is going up as well, and then from 2008 to now, the market is going up, while the ratio has huge swings.

In other words, during this third period, the volatility (or the dispersion of highs and lows) of the IV/HV ratio is increasingly high.

The swings are large and that does not bode well for the market. What this last period is telling me is that although the market has been going up, investors are highly skittish and nervous. Clearly, this does not tell us what the market or what the volatility will be next year, but it does confirm what everyone is thinking -- that our economic and market future is shaky.

A prudent investor should be conservative and allocate less to risky assets and more to alternative strategies, which are non-correlated to the major market indices.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
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