Volatility Is Dangerous for the Markets

By Alex Gurvich, portfolio manager at The Rockledge Group

NEW YORK ( TheStreet) -- I spoke at a conference recently, presenting my ideas about generating alpha.

As I spoke, some folks were nodding their heads in agreement, some were doing their BlackBerry prayer and some were simply not present. Typically that's how it would end: some exchange of ideas, a nice conversation, but no more.

But I had more to say. I started talking about volatility and how it affects the generation of alpha. The effect, unintentionally, was amazing: The heads went up, the BlackBerrys went down and the room became focused. It was as if everyone had been given an intravenous injection of 5-hour Energy.

So what is it about volatility? The standard textbook definition I teach to my finance students when I am not managing client portfolios is that volatility (or standard deviation) is the square root of variance, which is the sum of squared deviations of stock returns from its mean.

Now if that is not a mouthful, I don't know what is. It is certainly not this definition that makes people pay attention. A more common definition of volatility is the riskiness of a security.

There is something about volatility that simply gets everyone's attention. Although I wish I could take credit for the reaction I got at the conference, it was the mention of volatility that generated the excitement. Volatility typically brings out gut reaction and gets everyone excited. It is like a roller-coaster, exciting and scary and the same time.

The higher the volatility, the stronger our reaction up and down.

It is well documented that current volatility is considered low. The chart below shows the level of the S&P 500 index on the left scale and the rolling 12 months of volatility on the right scale.

The reason everyone perked up when I started speaking about volatility is I raised an issue everyone has buried under the carpet as of late. No one, whether in the audience or my company's clients, believes volatility should be this low, but we don't talk about it.

There are many things that are driving this view. The economy is sluggish and the main barrier to growth is unemployment, which is stubbornly high. We have the "fiscal cliff" situation that, if not resolved, can potentially slow the recovery. The European recession is in full swing and there is some risk of a breakdown of the European monetary union. The on-again, off-again crisis in the Middle East in Syria and, more significantly, the confrontation with Iran can drive even more uncertainty in the world markets.

In addition, the implied volatility is low as well. The implied volatility has many explanations: There is the fundamental financial definition that says it is based on today's option price of the S&P 500 index, from which the future (or implied) volatility can be derived using the Black Scholes option pricing model.

But, more commonly, implied volatility is called a fear factor or, as some contrarians call it, the complacency factor, depending on your own perspective of the market. We even have a well-established index that tracks this; the VIX, which is the 30-day derived (implied) volatility based on current S&P 500 option pricing.

Even if you look at the VIX chart, you can see how low, relatively speaking, is today's implied volatility. The chart also illustrates how the fear factor is always opposite of the booming market: When the market is going up, the fear factor (i.e. the VIX) goes down, and when the market is going down, the VIX goes up.

Looking at both charts, we could conclude that investors are confident of the future market direction and, despite many domestic and global uncertainties, they don't foresee major market gyrations in the near future.

That, of course, can be the end of the story. Unfortunately, it does not satisfy my own curiosity, nor does it allay any of my risk-averse fears. Fortunately, there is another way of looking at volatility, which may provide some answers to us, or at least allow us a glimpse into the future.

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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