Climateer Quote of the Day: Volatility Edition (VIX)

Upfront, the prestigious QotD has to go to the Reformed Broker for something he wrote May 25:

The greatest trick Wall Street ever pulled was convincing Main Street that Volatility was the same thing as Risk.

I've always gotten a kick out of  sitting in a meeting and hearing someone say vol=risk. My first thought is "I have a shot at taking all your money". My second thought is "Crap, does he work for me?"

This feral greed/fear insight into my psyche is a good jumping off point for something flagged by Izabella Kaminska from Bloomberg's Matt Levine:

The VIX Is Not A Great Way to Measure Complacency

A basic story that is told over and over again about financial markets is:

• Things mean-revert.
  
• A thing is away from its mean.
  
• Therefore that thing will mean-revert.
  
• Soon and horribly.¹
  

This is I think roughly the way to read the notion, which my Bloomberg View colleague Mohamed El-Erian examined today, that low readings on the VIX -- an index of implied volatility in short-dated S&P 500 index options -- mean that the market is "complacent." So:

• Equity volatility is basically a mean-reverting thing.²
  
• The volatility index is below its long-run average.
  
• Therefore volatility will go higher.
  
• Soon and horribly.
  
• Run, you fools!
• Why are you being so complacent?

There are some simple problems with that story. One is that "things mean-revert" does not actually prove that "this thing will mean-revert soon and horribly": Sure, things will eventually get more volatile, but the fact that things are especially calm now doesn't prove that they'll be much more volatile soon.³ There is an obvious analogue to this problem in stock prices: Stock valuations seem, by some measures, to be high right now, and valuation multiples are roughly speaking mean-reverting, So maybe that means that future returns will be low. But that is not necessarily a good reason to sell stocks.⁴
 
And there is a further problem. A share of stock is a perpetual thing, more or less; you can talk sensibly about stock valuations reflecting people's expectations for the coming, like, decades. Uber is not valued at $17 billion based on this year's GAAP net income. The VIX, on the other hand, is a necessarily short-dated thing: It's implied volatility for the next month.⁵ If you expect 2018 to be a great year for Uber, go ahead and bid up Uber's stock. If you expect 2018 to be volatile, there is absolutely no reason to buy options on the S&P 500 index that expire in July 2014. Those options will do nothing for you in 2018. Stock prices discount the entire future, somehow or other. The VIX discounts a month.⁶

...MORE

Look at that, five paragraphs in and Matt is already up to six footnotes! The man is a superscripting machine.

I mentioned one of my favorite measures, semi-variance, in a post that was also inspired by Ms. Kaminska (caution: multiple self references ahead):
Barron's on Gold and Real Interest Rates

...From our "Spot Gold Down $21.80 as HSBC, Credit Suisse Lower Forecasts (GLD)":

Back in early December FT Alphaville's Izabella Kaminska modestly wrote in "Capping the gold price":

The following chart, we propose, has the potential to inspire a whole new way of looking at the gold and Treasury market...

Now if you cut out the upside (...Capped) you are left with the semi-variance which means you can figure out all kinds of extremely high reward bets....

The semi-variance link goes to Investopedia who write:

Definition of 'Semivariance'

A measure of the dispersion of all observations that fall below the mean or target value of a data set. Semivariance is an average of the squared deviations of values that are less than the mean. The formula for semivariance is as follows:

Where:
n = the total number of observations below the mean
r_t = the observed value
average = the mean or target value of the data set 

Investopedia explains 'Semivariance'
Semivariance is similar to variance; however, it only considers observations below the mean. A useful tool in portfolio or asset analysis, semivariance provides a measure for downside risk. While standard deviation and variance provide measures of volatility, semivariance only looks at the negative fluctuations of an asset. By neutralizing all values above the mean, or an investor's target return, semivariance estimates the average loss that a portfolio could incur.

For risk averse investors, solving for optimal portfolio allocations by minimizing semivariance would limit the likelihood of a large loss.

Leading us to:

1) Understanding why Izzy's Capping the Gold Price was so interesting.

2) Sam Cooke singing Johnny Mercer, naturellement:

You've got to accentuate the positive
eliminate the negative
Latch on to the affirmative
But don't mess with mister inbetween
You've got to spread joy up to the maximum
Bring gloom down to the minimum...

Less melodic but still on key is the hot new duo Fama/French.