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No Volatility


The current 30 day average volatility for the SP500 is 15%. The current 30 day average volatility for 30 year government bonds is 15%. This is unprecedented (they were somewhat equal back in 1998, but that was at very high levels and due to an extreme exogenous shock to the system) and I believe has significant implications.

How can bonds, being supposedly much less risky than stocks, trade at an equal volatility? I maintain they can't, at least not naturally. I have commented on what I believe are the reasons for higher bond volatility, but I cannot explain why stock volatility should drop in the face of it, unless I allow for the possibility of a broad and well organized effort to make it so.

About the best way to increase confidence for investors, getting them to feel good about buying stocks, is to reduce volatility. This is a little of the tail wagging the dog, but it has a very profound logic to it. Several experienced traders I talk with all agree that this rally has seemed unnatural, that stocks just don't act this way, at least in our experience. Let me show you what we mean.

A positive tick occurs on a stock when the next trade is higher than the last. Traders watch the cumulative ticks to see how aggressive buying in any given time period is and compare that to volume. From March through June of this year ticks have gone positive by 1000 (1000 different stocks) at least one time each day in 95 of the 100 subject trading days (Todd has spoken of this). This by itself is unprecedented. More curiously, a very high percentage of these occurred when the market was actually down on the day. Now, any intelligent buyer of a stock when that stock is down on the day would most likely buy by bidding, and not all of a sudden begin taking offers in a panic. It is as if the buyers wanted to pay higher prices. This also cannot be argued away as short covering: short covering may cause ticks to go more positive than they already are and normally occurs when markets are already rallying, not declining. In addition, in my opinion, the short base is not being properly represented statistically and is actually dangerously small: a huge part of short interest is against convertible bonds and other derivatives and is actually delta neutral, requiring covering only when markets are down and selling more when markets are up. The other thing we have noticed is that every piece of bad news is met with buying, as if it were the last piece of bad news before the really good news comes out. Bad news gets no respect.

This type of action has had a major impact on actual volatility and investor sentiment. Traders have been conditioned to buy dips and do it aggressively. Psychology has changed from fearful to confident during this period and now remains at very high levels. Volatility in the SP500 has dropped from 26% to 15%. This has occurred as bond volatility has risen from 9% to 15%. The truly ironic thing is that with interest rates low and earnings in a trough (I will not argue against the fact that they are turning up, for even though I believe it is a mere blip due to cost cutting, I don't have to argue this far to make my point), stocks should be much more susceptible to higher bond volatility than when rates are high and earnings are peaking.

All this looks very suspicious to me. I remain a buyer of volatility.
No positions in stocks mentioned.

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