What Does the VIX Mean?

In a couple recent blog posts looking at the state of the stock market, I have referred to the VIX. It has occurred to me to dig a little deeper to find out what the VIX measures and how it can be interpreted. The results were a little disappointing, but not altogether unsurprising.

First, the VIX is a measure of expected volatility, when I thought it was a reporting of experienced volatility. I didn’t realize that the VIX is quoted in percentage points.  That makes sense, since it’s a measure of the implied volatility found in S&P 500 option contracts. According to Wikipedia (fount of all knowledge), the VIX “translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. For example, if the VIX is 15, this represents an expected annualized change of 15% over the next 30 days; thus one can infer that the index option markets expect the S&P 500 to move up or down 15%/√12 = 4.33% over the next 30-day period.”

It was pointed out that volatility doesn’t necessarily mean that markets are expected to fall. A market that is expected to quickly rise will also translate to higher volatility. But what the VIX is reporting is people’s expectations. When people expect the market to rise, they expect it to rise consistently and orderly. When people expect the market to fall (continue falling), they expect the worst.

So the VIX turns out to be similar to a measure of sentiment. During the market crash, sentiment was poor and the VIX was high. Alternatively, when the market appears to be rising, sentiment is good and the VIX is low. But since investors, even professional traders who deal in S&P 500 futures, have been shown to be unable to predict the market behaviour over the coming 30 days, the VIX reflects current sentiment and is unuseful as a predictor of future market returns.

 

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There’s Always Something to Do

Peter Cundill passed away in January 2011 at age 77. A biography was written about him, called There’s Always Something to Do: The Peter Cundill Investment Approach. It was completed while Cundill was still alive, but arrived in the library after his death. I just finished reading it (I had to wait my turn for the only copy) and I thoroughly enjoyed it. I found the title to be ironic, however.

I am personally partial to the value style of investing. It matches my upbringing and training, and it’s familiar to me. I also appreciate the idea that investing is like a puzzle and work in research will be repaid with profits in the stock market. The many anecdotes, of successes and failures, were fascinating.

I immediately noticed two characteristics which seem to account for success. First, Peter Cundill’s heritage was described, and he came from a family who, after they immigrated from Britain to Canada, were entrepreneurial and amassed great wealth. The fortune was lost while Cundill was young, but it is very apparent that he benefited from connections. He was able to begin work with people who were well placed to mentor him and provide him with opportunity. He also had an ability to form a network of people who gave each other mutual help in their work. This is a phenomenon that I have heard and read about, but which I don’t yet understand myself. I believe it’s one of the main advantages that influential people have, which they probably learn in their families.

Second, Cundill continually preached patience. Many of the companies in which he invested took two years or longer, during which the share price sometimes continued to fall, before his decision was vindicated and his investment turned profitable. Given the repeated exhortation to patience, the title may mislead. In life, unlike in investing, there’s always something to do. Cundill was a man who was curious and had many interests. When he wasn’t engaged in investment research, he ran, he exercised, he attended museums, ballets and operas and he read voraciously. But as the investment anecdotes showed, especially in the case of selling the Japanese market short during the mid-1980s, sometimes there’s nothing to do but wait for the market to realize its mistake and adjust prices.

As the biographer pointed out, Cundill paraphrased John Maynard Kaynes’ well-known adage: “Markets can remain irrational a lot longer than you and I can remain solvent.” So I would say that in investing, there is always something to do, if you count patiently waiting for the market to realize its error as doing something.

Housing Affordability

I overheard a conversation in which one person was lamenting to another that as interest rates rise, housing affordability will worsen and soon only 1% of people will be able to afford to buy a house. I’m sure that was an exaggeration, but I’m still interested to look at the scenario.

How many people pay cash for a house? Not many, I’m sure. Almost all buyers have a mortgage of some size. Recently, the length of a mortgage that CDIC would insure was reduced from 40 years back to 35, but hopefully not too many buyers took advantage of the longer amortization. Let’s use, as an example, an amortization of 25 years. What is likely to happen to house prices as interest rates change?

Let’s assume a $400,000 home (pretty typical in Calgary) and an interest rate of 5%. The 25 year cost, at monthly payments of $2338.36 is $701,508. If interest rates fall to 4%, I would expect the house price to rise to $443,000. In that case, the total cost would remain $701,508, no change for the buyer. On the other hand, if interest rates rose to 6.25%, I would expect the house price to drop to $354,500. Again, no change in the total cost to the buyer. While the house price changes with shifts in mortgage interest rates, there is no real change in affordability on average.

I say “on average” because the total cost depends on the amount of debt, the length of the amortization and the interest rate. Let’s see how the total cost changes for buyers who pay cash, compared with buyers who were “lucky” to get a 40 year amortization. For the buyer paying cash, the total cost is the same as the nominal costs above. A rise in interest rates (from 5% to 6.25%) would result in a price that is $45,500 lower, whereas a lower interest rate (4% instead of 5%) would result in a price that is $43,000 higher. In contrast, the buyer with a longer amortization will benefit in the opposite way. If interest rate were to rise as above, total cost would rise from $925,819 to $966,067, an increase of $40,248. If interest rates were to drop as above, total cost would fall from $925,819 to $888,705, a decrease of $37,114. On average, affordability should remain unchanged while house prices move inversely to interest rates, but the actual change in cost will depend on a buyer’s level of indebtedness.

Real changes in affordability stem  from shifts in supply and demand. As an example, around 2005, Imperial Oil moved their head office to Calgary. At the same time, many Imperial Oil employees moved from Toronto to Calgary. The price of our 1550 sq ft, two storey home jumped from roughly $250,000 to around $400,000. That wasn’t the only source of net immigration to Calgary, but a sudden increase in demand without an offsetting increase in supply caused house prices to jump, driving down affordability for everyone (notably my younger siblings).

What happened during the US housing meltdown? During the period 2000 – 2007, interest rates consistently fell while mortgage terms stretched longer. This pushed house prices up (lower rates), but also brought costs to borrowers down (lower rates). Apparently, many renters became first time owners, increasing the demand. Increasing demand pushed up prices further, but reduced affordability (increasing total cost), causing banks to respond with “creative” mortgages (teaser rates, balloon payments) which further lowered costs to borrowers in the short-term. But once the teaser rates expired, affordability suddenly worsened for owners who were heavily indebted, and when sales (added to new construction) first surpassed purchases, supply began to outstrip demand. That pushed housing prices back down (market mechanism), sparking a panic.

A US-style housing meltdown has so far not affected Canada. The question that continues to surface from time to time is: could it? I can see two scenarios where the danger is a real possibility. First, residents could migrate away from Calgary (and Vancouver, Toronto and other cities that experienced a jump in house prices) back to lower priced markets (such as the Maritimes). This seems less likely as long as the economy recovers and jobs continue to be available in metro areas. Second, as interest rates rise, owners may encounter trouble as they try to renew their mortgages. Higher interest rates mean a higher monthly (and total) cost, but this can be offset by extending the amortization. My guess is that the worst case would be that some people who over-extended their borrowing will continue to own a house with a 35-year mortgage, continually renewing for 35 more years. Short of an economic meltdown (which luckily seems to have mostly bypassed Canada) or a demographic shift (the baby boomers all try to sell at once), house prices seem likely to remain relatively stable.

Investing like the rich…

While my opinion often differs from Michael James, I appreciate his perspective. I particularly enjoyed his post on investing like the rich. He makes two valid points: the rich (generally) didn’t make their money in the stock market and they aren’t necessarily successful when investing in the stock market.

This is no secret. I’ve read a number of books that have pointed this out. Think about any successful person you know. How did they make their fortune? Almost all of them made their money by owning or running a business. A single business, without diversification. That investment of time and energy, if not capital, provides an investment that is understandable and is under the control of its owner. All the information about operations and results is available, and the owner can make whatever changes he sees fit.

When the owner sells his business, the question becomes: what to do with that money now? Buying businesses makes sense and is probably comfortable for the prior business owner. Buying a share of a business is exactly what the stock market is for. The business owner is then able to put their capital to work, spread the risk across a number of ventures, and continue to collect business profits (as dividends).

The problem arises from the differences. First, ownership through shares is totally hands off. Complete information isn’t always available (although, to be fair, many companies make an effort to provide clear and complete information), and the influence of shareholders over operations is at best indirect. Once a portfolio of businesses is collected, generally more than 20, it becomes very complex to stay abreast of all the information and external conditions affecting the portfolio of businesses.

If the rich were to treat their stock investments the way they treated the businesses in which they made their fortune, they would be more successful. It would certainly go against modern portfolio theory, and the sales pitches of large financial firms. How do they hire people? They look at qualifications, experience, ability and they measure results. How do they ensure their business is on track? They are involved on a regular basis, and they set and meet targets. Finally, they don’t buy and sell their own business on a regular basis.

If we invested the way the rich run their business, I think we could expect better results. That’s why I own a small number of business, trade infrequently, read financial statements and participate in conference calls. I also don’t expect every quarter to be better than the last. The economic environment, as well as the individual company context, fluctuates over time. I expect results to deteriorate and improve over time. For this reason, it doesn’t make sense to jump in an out of a company’s shares except in response to opportunities that arise from price fluctuations.

I try to run my investment portfolio as a business, where I hire managers to function on my behalf and to be accountable to me (within reason). If I lose confidence in a company, I will sell it, and find another company I can depend on to produce results. This can be complex, since there is an interplay between the various businesses I own (they react differently and on a different timeline to external forces), as well as the impact of price movements in the marketplace.

Money

I admit, I got sidetracked. Instead of writing a blog post for today, I read everything on this chart:

http://xkcd.com/980/

It reminds me a little of an Andex chart, in that it’s packed with too much information. But in this case, the information is way more dense. The artist listed 5 (6) things that he learned in researching the chart. Here are five things I learned:

  1. A dinner at McDonald’s is cheaper than a homemade chicken dinner, or even a homemade dinner of pinto beans and rice, if you include shopping for two hours, travel, prep and cleanup (at $16.27/hr). The moral: don’t shop every single day.
  2. Between 1965 and 2007, worker compensation has remained constant, after adjusting for inflation. CEO compensation, conversely, has exploded. In 1965, a CEO earned 25x the hourly wage of a worker. In 2007, the CEO earned 275x the worker’s wage.
  3. In America (and probably across Western democracies), the government taxes the rich more than the poor, but FAR from proportionally to their income generation.
  4. The American government currently funds about 40% of its spending programs using debt. On a related note, Canada has a little more debt than the US in proportion to GDP.
  5. The combined pay at banks and Wall Street firms is about half of combined teachers’ salaries. In a similar vein, government spending on K-12 education (in the US) is less than a third of total spending (including privately) on health care.
  6. In the US, the government consumes almost 14% of GDP. In contrast, education costs 1.1% of GDP.

Stock Market Rhythms

Ned Goodman, long-time professional investor in Canada, likes to say that history may not repeat itself, but it often rhymes. There are many views that, while history may not predict the future, we can learn from history. There is also a sense that, when investing, timing is important. Here are various perspectives on the rhythm of market movements.

Wave theory exists on a number of scales. The Elliot Wave Theory, for example, suggests that patterns exist in scales of decades, years, months, days, hours and minutes. Further, it suggests a regular up-down-up pattern.

Technical cycles suggest that the market changes direction or changes rhythm on predictable timeframes. These might be cycles of 21 days and 105 days, or it might be cycles (based on moving averages) of 50 days and 200 days. Looking at these timeframes will help a market watcher to predict how long the current trend will last, and whether the trend is likely to reverse itself.

On the one hand, these cycles may have a base in human psychology. People tend to change their mood based on their circumstances, their environment and the moods of others around them. This is demonstrated in seasonality and herding in the market. On the other hand, our human brains are basically sensitive pattern-detectors. Because we are so determined to find patterns (which easily compress, to save memory and decoding effort), it becomes easy to see patterns even in randomness. It is very difficult to know whether cycles exist, possibly due to human behaviour, or whether we are finding patterns in noise.

Another example of the rhythm of markets is trading time. I first heard this term used when reading the work of Benoit Mandelbrot. According to Mandelbrot and consistent with my experience, time isn’t experienced as a uniformly advancing phenomenon by stock traders. Certain events cause time to speed up or, rather, for more actions (trades) per minute to be effected. These may include a news item, a corporate action, such as a merger, the publication of a revised forecast or a financial document. It might also be in response to other actions in the market, such as a sudden large buy or sell order or a change in price of the shares of a competitor. Traders will review this information and (more or less) quickly decide whether or not to act based on the new information.

When a person is considering investing in the stock market, they should start small and come to understand the rhythms of the market and of their specific stock picks. Individual companies may have a unique rhythm, based on earnings reports, changes in outlook, news items and large trades or participation in the market of strong and weak traders. This is the kind of benefit that comes from experience and can help a person gain a small advantage.

Per stock momentum

I’ve been watching the momentum of different asset classes, in order to determine what to own. So far, it’s worked extremely well. When stocks aren’t in favour, investors may profit from owning bonds or gold. When bonds are out of favour, and investor might do well by owning large cap stocks, small cap stocks, or emerging market stocks. Each of these asset classes tend to move differently.

Individual stocks don’t seem to necessarily move differently, in the way that asset classes do. Large cap stocks all tend to move with the market, except when news is reported that affects earnings or expected profitability. As I applied my momentum methodology to large cap stocks, I found very few stocks that moved differently enough that I could form a portfolio. When I did, the portfolio had high turnover (short holding periods) and disappointing performance.

By owning 5-8 stocks over a period of a month and a half, the large cap stocks that I picked and traded, based on momentum, have under performed the TSX by over 5%. But what was worse was noting that certain stocks moved from in favour to extremely out of favour, and then back in favour over a small number of weeks.

Perhaps the issue is the ranking formula I used. I ranked all the stocks against each other, giving equal weight to fundamental criteria (P/E and debt-equity ratios) and momentum criteria (price growth) which overweighted recent time periods. The goal was to benefit from both value and momentum styles, but the results have been disappointing. Perhaps removing the value screen and investing purely by momentum would yield improved results.