Tuesday, June 21, 2011

Suppressed Volatility

FT Alphaville has a post Crouching Vix, Hidden Volatility claiming that:

Volatility is out there. You just have to look for it — and not by glancing at industry-standard, the CBOE Vix index.

The blog then points to a post by ConvergEX that states:
If you only focused on the CBOE VIX Index, you’d be tempted to think that the recent market volatility was pretty modest.
The problem is that it wouldn't only be a temptation, it would be a fact.

Looking at implied volatility, as defined by the VIX, relative to actual realized three month volatility of the S&P 500, the VIX has (much like most of history) been consistently overstating volatility (the VIX recently closed at 19 vs. three month realized volatility of 12, a difference of 7 relative to the average difference of 4 over the previous 20 years).

This isn't to say that I believe the VIX accurately reflects the economic environment and risks associated with investing in the current environment (I absolutely don't). It just isn't some conspiracy theory that the VIX is being artificially suppressed relative to the underlying market or that volatility is more accurately reflected in other sectors.

It is simply (in my view) that volatility across ALL sectors and asset classes has been suppressed by the liquidity that has successfully (to date) been finding its way into riskier and riskier asset classes following the combination of unprecedented fiscal / monetary stimulus and a lack of "real" investments (i.e. investments that feed into economic growth and create jobs) for this liquidity to go.

So tread carefully my investment friends. The part of the investment cycle where an investor can generate positive returns by simply providing liquidity to the market is likely over.

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