Need a break from reading about the failed Bailout and Madoff’s $50B-Poof drama? Consider the Volatility Bubble – anything can turn into a bubble these days, for instance, investments with zero returns, bailouts (to others, not you), and volatility. 
A Volatility Bubble?
Courtesy of Adam Warner at Daily Options Report
Are we in one? Well, I do so love calling everything a bubble. Not. But this sure feels like a long period of extended advance in an asset class or statistic. This from Bespoke (hat tip Abnormal Returns).
A couple of weeks ago, we did a post showing that the 50-day average daily change of the S&P 500 was higher than at any other point in the index’s history. After yesterday’s close, another record was eclipsed when the average daily change moved above +/-4%! As shown below, this volatility blows away even the highest levels reached during the Great Depression.
Up until the start of 2008, a daily move of 4% in a 50-day period was noteworthy. From 1945 through 2007, the S&P 500 had 49 one-day moves of 4% or more, which is an average of less than one per year. This year we’ve had 28! For a market as big as the United States to average a 4.02% daily change over a 50-day period is truly astounding. This is the type of volatility that we see in frontier and emerging markets — not the biggest, most developed market in the world. The volatility bubble won’t last forever, and being long it at this stage of the game is a very risky bet.
Now as to that last sentence, I would be more specific. The market is assuming a bit of a new normal here in volatility. Which if it behaves like everything else in history, will become an erroneous assumption. We’ll revert to the old means someday. But that being said, there’s no saying when that happens. And the same way buying cheap volatility took forever to pan out in 2005 and 2006, it’s anyone’s guess when selling fat volatility will truly work in 2008 or 2009. I do think we get a down move soon as year-end approaches. But that’s likely just a blip.
And for now, as the graph this morning of IWM showed, options volatility still underprices actual market volatility.
So yes, careful loading up on 6-month paper. But keep in mind we’re already at unprecedented time at high volatility, so there’s no saying how much longer it will go. The market expects the party to continue somewhat, as May VIX futures still carry a mid 40’s tag.
In the meantime, remember it’s holiday season, the perfect time for a VIX Bikini.
