Was There A Key Change In Market Volatility Last Week?

As mentioned previously in this column several times, I reside in Chicago, Illinois. More importantly, my home address is in the Hyde Park neighborhood where the University of Chicago dominates the landscape. 

My path to Hyde Park is a story for another time, but I attended the University of Chicago Graduate School of Business between 1975 and 1977 where I was fortunate to earn a Masters in Business Administration. I never really appreciated the experiences I had back then until the last decade or so. Some of my legendary professors included Merton Miller, Myron Scholes, James Lorie, and Roger Ibbotson. Myron Scholes and Roger Ibbotson, in hindsight, were the most influential on my eventual career path (options trading, valuation, and securities research). Eugene Fama, the latest winner of the Novel Prize in Economics, was also teaching at the University of Chicago GSB when I was there between 1975 and 1977. While I never attended any of his classes, our paths crossed on the campus tennis courts one afternoon back then where we rallied a few minutes before our actual playing partners arrived at the courts. For both of us it was an insignificant moment in time, but our paths would cross again about 35 years later. For me, this 2nd crossing was monumental, but I am a bit sad to report that for Mr. Fama this second crossing was even less significant than our first crossing and not the least bit memorable for him (LOL). Such is life sometimes for the great unwashed when in the company of royalty!

My two children attended school (K-thru-12) with several of Eugene Fama's grandchildren, and my wife and I are friends with Beth Fama and Chicago Booth Professor John Cochrane who are Eugene Fama's daughter and son-in-law. We were invited to a party sponsored by the Fama-Cochrane's and I had a chance to "reconnect" with Eugene Fama in a short one-on-one conversation. I "re-introduced" myself to him, made small talk for only a moment or two, and then asked him the single most important question of my life. "Mr. Fama" I asked, "is volatility a meaningful factor in predicting stock prices?" Mr. Fama didn't hesitate with his response. "We've looked at that and the answer is NO", with emphasis on the "NO". There was no rebuttal expected from me and none offered. That was it. Conversation over. Verdict in. No discussion or appeal!

While I was not surprised at Mr. Fama's response, I will admit to hoping for at least a short follow-up discussion. But the window was closed, and we were in fact at a party where "business" discussions are frowned upon and sometimes not even proper etiquette.

For those of you who would blindly accept Mr. Eugene Fama's verdict regarding the relationship between volatility and stock prices, there is no need for you to read the rest of this column. After all, Mr. Fama is the deserving winner of the latest Nobel Prize in Economics. And if there was a "Hall of Fame" for academia, Eugene Fama would surely be among the first voted in. However, as incredible as it sounds, I think Mr. Fama's conclusion regarding volatility as a predictor of stock prices may be "less than 100% accurate". My humble research would suggest otherwise. At a bare minimum, volatility is an interesting tool for anyone foolish enough to attempt to forecast stock prices. 

And for all those fools who might be inclined to listen to this fool, here's what I know and here's what I think it all means:

1. I believe that a major change in volatility is about to unfold across almost every market (stocks, bonds, commodities, and currencies). Please see chart below of current historical implied volatility for stocks and currencies.

2. The basis for this extraordinary claim is the significant uptick in actual volatility that was posted last week in the Gold and Silver markets.

3. Single-day volatility in Gold and Silver jumped to 23 and 38, respectively, last Thursday, June 19th. With a few exceptions, daily price volatility in both these key precious metals has been languishing between 2 and 10 this year so far. 

4. 10-day volatility in Gold and Silver has jumped to 17 and 30, respectively, up from 5 and 7 respectively in early June 2014. Please see charts below.

5. A buy signal was triggered within my computer trading system in the closely-watch CBOE VIX Index on Friday, June 20th, despite the fact that the S&P 500 Index  posted one of its lowest single-day volatilities on record at 2.40 for this same day! Please see charts below.

For argument sake, let's say that I am right in my prediction that a major increase in volatility is imminent. Since we are now near record lows in volatility, this prediction shouldn't be a surprise and may even be shared by many Wall Street analysts. The key question then becomes, what will a major increase in volatility mean to U.S. stock prices?

Bottom Line: A major increase in market volatility across all asset classes will probably be the direct result of a massive increase in "investor uncertainty" which will then quickly translate into sharply lower stock prices. In the interest of full disclosure, I am short the S&P 500 Index using the ProShares Ultra-Short SDS ETF in my managed accounts.

CBOE VIX Index Daily Chart with Computer-generated Buy & Sell Signals, & 10-Day Volatility

S&P 500 Index Daily Chart with 10-Day Volatility

S&P 500 Index Daily Chart with Single-Day Volatility

Silver ETF (SLV) Daily Chart with 10-day Volatility

Gold ETF (GLD) with 10-Day Volatility

Iraq - June 2014 - Rebirth Of A Black Swan

From Wikipedia:

The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight. The theory was developed by Nassim Nicholas Taleb to explain:

1. The disproportionate role of high-profile, hard-to-predict, and rare events that are beyond the realm of normal expectations in history, science, finance, and technology
2. The non-computability of the probability of the consequential rare events using scientific methods (owing to the very nature of small probabilities)
3. The psychological biases that make people individually and collectively blind to uncertainty and unaware of the massive role of the rare event in historical affairs

The "black swan theory" refers to unexpected events of large magnitude and consequence and their dominant role in history. Such events, considered extreme outliers, collectively play vastly larger roles than regular occurrences.

At the age of 60 now, and with more than 35 years experience studying and trading the financial markets, I view the recent surge in violence within Iraq as the "rebirth" of a potential Black Swan. I think you would be hard pressed to find many Wall Street advisers or research analysts who had predicted imminent civil war in Iraq, let alone what is actually happening now which looks to me like a major transformation of this country and potentially the entire region. In my book, we are just in the first chapter of a new dawn of disasters in the Middle East, and Wall Street investors appear blind to the potential negative consequences to U.S. stock prices immediately ahead and over the next several quarters, at least.

Weekly Chart Sell Signals were triggered by my computer trading system last week in the following stocks and indexes: BA, COST, DHI, DIS, DD, F, HON, JBHT, KR, LEN, MUB, PEP, RTH, SWC, UTX, VIA, WM, XAL (Airline Index), and HGX (Housing Index). Five of these stocks are "blue chip" components of the Dow Jones Industrial Average. Please see Boeing (BA) and DuPont (DD) weekly charts below.

Gold/Silver stocks were the number one performing stock group last week, with the closely-watched Philadelphia Gold/Silver Stock Index (XAU) posting a 6.46% gain on the week.

On Tuesday, June 3rd, I reported in this column that daily chart buy signals had been triggered that day by my computer trading system in several major Gold/Silver stocks and indexes. The June 3rd closing prices for those stocks and indexes are posted here along with closing prices from yesterday, June 13th. Please refer to my column dated June 3rd for more details.

                                                      June 3rd               June 13th         Change

Agnico Eagle Mines (AEM)              $30.48                 $33.29              + 9.22%  

Gold/Silver Mining Index (XAU)        $84.98                $92.30              +  8.61%   

Barrick Gold (ABX)                          $15.97                $16.98              +  6.32%

Endeavour Silver (EXK)                  $  3.90                 $  4.84              +24.10%

First Majestic Silver (AG)                 $  8.44                $  9.59              +13.63%

Fortuna Silver Mines (FSM)             $  3.93                $  4.63              +17.81%

Gold Mining Share ETF (GDX)        $22.37                $24.11              + 7.78%

Newmont Mining (NEM)                   $22.82               $23.40              + 2.54%

In my view, the rally in Gold/Silver mining shares is just getting started.

After posting its lowest close since 2007, the CBOE VIX Index (also known as the "Fear Index") rebounded 13.51% last week to 12.18. And just like with Gold/Silver stocks, I think the rebound in VIX is just getting started.

In the interest of full disclosure, I am long Gold/Silver stocks (AG, EXK, GDXJ) in my managed accounts and also short the S&P 500 Index with the double-short SDS ETF.

Boeing (BA) Weekly Chart with Computer-generated Buy & Sell Signals

DuPont (DD) Weekly Chart with Computer-generated Buy & Sell Signals