Volatility Highs and Lows

Last week we talked about how the central bank liquidity creation has been the major driving force in the markets during 2009.

All of that money thrown into circulation has given us our current “sugar high” and will also provide us some accompanying side effects, most notably wild volatility swings.

This week, pictures are worth a thousand words!  Let’s look at a couple of charts that tell the volatility story really well.  First, here is a compressed daily chart (meant to show trends rather than detail!).

I wanted to show the full volatility cycle so my apologies for cramming so much data onto the chart.

A massive volatility contraction originated in 2000 and continued over into the first part of 2007.  While you don’t see 2005 and 2006 on this chart, you can see in the next chart that the ATR lines extended basically low and flat from 2005 into 2007.  Then in mid 2007, volatility picked up considerably as the market moved towards its top in October of 2007.

The fear in the markets in the fall of 2008 sent volatility to all-time highs, both in absolute terms and in relative terms.  When you view ATR as a percentage of price, at its height, the market was moving more than 8% per day on average!

As you can see from the chart, the market stayed in a state of extreme volatility for about nine months with volatility not waning until May of 2009.

Then a funny thing happened: volatility continued to drop.  And it dropped so far that we’ve only had a handful of days in the whole last decade that were as low as what we saw at the end of December.  To see that longer term perspective, let’s look at the same chart using weekly bars instead of daily ones.

Does anyone remember the volatility levels when the Internet bubble popped in 2000?  Relate that to the higher volatility caused by the recent collapse of the real estate/credit bubble.  Pretty dramatic increase, wouldn’t you say?

The other very interesting take away from this chart is the extent of the price retracement so far.  Yes, 2009 was a year of double digit returns, but we have gained back barely more than 50% of the drop from October ’07 through March ’09.

Volatility cycles are pretty well documented occurrences in the market, so while I’m generally not much for grand predictions, I will say one thing:  as sure as day follows night, we’ll get a volatility expansion after this volatility contraction. A market stretched to the upside on contracting volume will either lead to a blow-off top or a nasty short to intermediate correction.  So hang on to your hats ladies and gentlemen because, either way, we’re likely to see some pretty wild swings from here.