Volatility Squared

Adam Hamilton    November 17, 2000    3520 Words


We unquestionably live in volatile times.  Uncertainty seems to be the only constant in our fast-paced, chaotic modern society.  Wars and rumors of wars rage around the planet, markets teeter on the edge of greatness or implosion, and the phalanx of information we are all subjected to becomes stale mere minutes after it is dispatched.


It is truly extraordinary to sit back and reflect on how unique our current global society is from a historical perspective.  Five hundred years ago, the average human being probably did not travel more than twenty miles from where he or she was born.  They were probably exposed to less information in their entire lives than we have access to in a single copy of a daily newspaper from a medium-sized city.  Two hundred years ago, information still traveled like cold molasses, taking weeks or months to traverse continents. 


The concept of volatility has changed dramatically in the intervening centuries.  Historically, volatility was largely a local phenomenon.  Life was so predictable, and changes to the status quo so rare, that usually only something like a local war, or plague, or some other small-scale event in one’s immediate neighborhood caused any perceptions of volatility.  Today, with everyone in the first world exposed to real-time information flows that seem to dwarf the volume of the thundering Niagara Falls, volatility has become the rule rather than the exception.  Events from all over the world have the psychological impact of “locality”, because we learn about them on the Net or TV mere seconds after they occur.  Volatility has in effect become a public good, with exportation of local volatility worldwide occurring at the speed of light.  Even the usually fairly tranquil United States of America is caught in a turbulent cauldron of circumstance as politicos tussle and squabble, and that volatility has been exported around the planet at breakneck speeds via universal media coverage.


Those of us blessed enough to live in the United States of America are simply stunned with awe watching the surreal media circus that our once sacred Presidential election has become.  What was a very average at best (boring at worst) Presidential race has become the political adventure of the century.  Hungry partisans with bloodlust in their eyes circle around the besieged state of Florida, with their razor sharp knives drawn and ready for action.  Ad hominem assaults are swirling, blotting out carefully reasoned arguments.  The American public is being whipped into a fevered frenzy by the goofy media, who bear much of the responsibility for creating this mess in the first place.  Before polls were closed, before people had a chance to cast their vote, the media wizards declared individual states and even the election for one or the other candidate.  Working on sketchy and inconclusive information, the media was wrong again and again, whipsawing the public back and forth in a tremendously volatile way.  The ultimate bitter fruit this political volatility will bear for America is not yet evident, but chances are it will not be good.


Like the now hated and despised general American media, the US financial media gurus continue to shamelessly broadcast a specific agenda regarding US equity markets rather than simply presenting the facts to let thinking people decide for themselves what is really happening.  While the political volatility was spilling over into the NASDAQ, creating very dramatic sell-offs and rallies, the financial media, for the umpteenth time since March, was busy unanimously convincing the average American investor that the bottom was in.  This repetitive mantra is becoming very old at the moment for the alert and discerning.  Those with a functioning memory that can still recall back past the latest soundbite or sports scores remember well the edicts issued from bubblevision in the past six months. 


The wise pundits in the financial media have continually spewed comments like these…  “4500 is an absolute bottom.  This market is oversold.”  “4000 is a heavy support line.  It will hold and we will see a major relief rally.”  “3500 is dirt cheap on the NASDAQ.  The bottom has been put in.”  “3000 is unbreakable.  The NASDAQ is SO oversold and we are expecting a major rally into the end of the year.”  Yada yada yada.


Since the Wall Street cheerleaders were dead wrong on NASDAQ 4500, NASDAQ 4000, NASDAQ 3500, and NASDAQ 3000, why not actually look at some hard data and fundamental indicators to attempt to divine whether or not we have yet seen the elusive NASDAQ bottom?  Like the fabled Yeti, a NASDAQ bottom is “seen” by everyone, but no one seems to have managed to capture this wily beast.  While there are a myriad of different fundamental perspectives from which to search for a bottom, we will focus specifically on intraday volatility in this essay.


Intraday volatility is a straightforward concept.  It simply refers to the amount of movement any investment makes within a particular day.  It is calculated by subtracting the low of a day from the high of the day, and dividing that result by the previous day’s close.  It is typically expressed in percentage terms.  1%, for example, indicates an investment traded within a range that was within 1% of the previous day’s close.  The result is expressed as an absolute value.  It doesn’t matter, for instance, whether an investment gained 1% or lost 1% on a day, as the intraday volatility is always expressed as a positive percentage.


Raw volatility series are difficult to analyze because they appear to be quite random when graphed.  For instance, one day might have a 0.1% intraday volatility, the next might have 3.4%, the next day may have 1.2%, etc.  When raw volatility numbers are graphed, it looks like a something a two year old child might draw by holding a crayon and violently moving his hand back and forth on a piece of paper (or a wall).  In order to observe meaningful trends, we took this ugly raw daily volatility data and applied a 100 trading day moving average to it.  The 100 day moving average greatly increases the signal to noise ratio of the information, and allows meaningful comparisons to be made.


In this essay, we will examine five famous historical crashes and/or bear markets and look for a particular volatility “signature”.  Then we will take a look at the NASDAQ as of November 15, 2000 to see if it appears like a bottom has indeed been put in from an intraday volatility perspective. 


All our highly valued Zeal Intelligence subscribers may wish to skip to the final historical graph (the fifth graph).  We presented these exact five historical examples in the August issue of Zeal Intelligence, while the NASDAQ was trading around 3800.  In that briefing, we explained that the NASDAQ bottom would not be obtained until a specific volatility signature was observed.  So far, the predictions gleaned from that initial volatility study have proved rock solid and right on the money.  This essay builds on and fleshes out some of our initial volatility research.


We will begin with the most famous market crash in history, the ever-fascinating DJIA crash of October 29, 1929 and the resultant nauseating multi-year bear market…



The DJIA is the blue line and is measured on the left axis.  The 100 day moving average of intraday volatility is the red line and is coupled to the right axis.  The first interesting observation the graph yields is the initial spike in intraday volatility, capped with the green dotted circle.  This initial spike rocketed up immediately after the crash, and is a very obvious anomaly on the volatility chart.  No matter what market we study, we always find an initial volatility spike that clings to the heels of the initial crash event.  The 1929 DJIA debacle was followed by a mighty bear market that gouged its pound of flesh from virtually everyone playing the Great Game at that time. 


Two more volatility tops are observed in the right half of the graph.  While these COULD be viewed as two separate tops, we believe they were actually a single drawn out double volatility top.  The ultimate peak in volatility did not occur until after the foundation of the bear market bottom was truly laid in the early 1930s.  The blue DJIA line reaches its lowest point on the graph slightly before the red intraday volatility line attains its ultimate summit.  In essence, we observe a specific volatility signature beginning to emerge.  An initial volatility spike leaps forth following the bursting of the infamous 1929 bubble, and a secondary volatility spike culminates shortly after the bear market bottom has been seen.  A DOUBLE VOLATILITY TOP (the initial post crash spike on the left and the secondary post bear market bottom spike on the right) is clearly seen in the most famous market disaster in history.


Is a similar double volatility top signature observed in another famous bear market in equities, the grinding bear of the mid 1970s?



In the early 1970s the DJIA experienced another very ugly bear market.  The venerable index dropped from well over 1000 to under 600.  Many of the old-timer brokers occasionally paraded on bubblevision are still marred by the ugly bear scars of trading and managing money in equities during these trying times.  Provocatively, another double volatility top is clearly observed!  Although there was no memorable “crash” event associated with the humble waking months of the mighty bear, a distinct initial volatility spike is observed following a rather rapid and dramatic decline in the premier blue-chip American stock index.  The second volatility spike occurred shortly after the depths of the bear market bottom had been plumbed.  A clear double volatility top is observed in the DJIA during the early 1970’s bear market.


Although the DJIA is the primary US stock index, it represents the stocks of only 30 companies.  In order to see if the double volatility tops could also apply to a broad market index (like the 100 stock NASDAQ 100 or the 4,500+ stock NASDAQ), we ran the same analysis for the same period of time against the S&P 500, which represents the 500 biggest and best companies traded in American markets.



Interestingly, the S&P 500 graph of the 1974 bear market is virtually identical to the DJIA graph of the same period presented above.  Yet another very distinct double volatility top is observed.  Actually, with the much broader S&P 500 index, the double volatility top is an almost undistinguishable clone to the much narrower (fewer companies represented) DJIA index’s double volatility top.  The graphs ARE different, but the differences are very subtle and are immaterial.


After the 1929 crash, the second most notorious market crash the US markets have witnessed happened one autumn day in 1987.  On October 19, 1987, the DJIA plummeted ferociously, losing more value in percentage terms than it had lost on October 29, 1929.  Although the odds of success were small, an anti-free market intervention by a strike team of large money-center banks led by the United States Federal Reserve injected unfathomable amounts of liquidity into the system following the plunge.  The literal deluge of capital wrought a near miracle and was able to short-circuit the dangerous emotion of fear growing in American investors, the “crash” was frozen in its tracks, and the DJIA resumed its bull market.  As the market curiously continued its upward trajectory right after the crash as if nothing had happened, this is really not an example of a “normal” bear market scenario.



In this exceptional case, there was really only a single volatility top.  There is a small initial spike of intraday volatility that happened before the crash, which is circled and noted with a green question mark, but the spike is so small it is stretching credibility to label it a volatility top.  Immediately after the crash, as expected, there was a massive spike up in the 100 day moving average of intraday volatility that culminated in a decisive top.  Due to the extraordinary intervention by the Fed and its consortium of banks, the bull trend of the market resumed immediately while the bear continued hibernating in its cave.  The light blue dotted line is the linear trend of the DJIA data series, and it is NOT in a bear market orientation. 


Because the usual historic pattern of bubble, crash, bear market, and finally bear market bottom was truncated through government mucking around in the markets, the double volatility signature is not observed in the 1987 crash.  Rather than letting the healthy bear cycle run its course to sop up speculative excess, the US Federal Reserve decided to allow the speculative imbalances to continue to grow.  With official sector coddling, the bubble grew and grew.  It was nurtured slowly until 1995, at which point the M3 money supply took off like a fox with its tail on fire, witnessing compounding growth rates and levels unprecedented in history.  Much of the new blizzard of monetary liquidity found its way into US equity markets, ultimately begetting the infamous NASDAQ bubble of 2000.  Since the 1987 event was an extraordinary occurrence that did NOT really reflect normal free-market forces, it is not surprising the double volatility top signature did not appear.  As the Federal Reserve and its cronies openly admit today that they “saved the system” through blatant intervention, we believe the lack of the double volatility top signature in this case simply reflects the fact that a normal bear market was delayed.


Even across the deep blue oceans in foreign markets, the double volatility top signature that marks a major bottom is readily apparent…



Everyone who has studied markets marvels at the incredible speculative mania, bubble, burst, and resultant 11+ year bear market that occurred in Japan.  The Japanese bubble of 1989 was at least based on something tangible, real estate, unlike the NASDAQ bubble of 2000 where ludicrous valuations were based on nothing but blue sky promises and near-religious faith in technology.  At its peak, the real estate in the city of Tokyo alone was “worth” more dollars than the entire nation of the United States.  Single blocks in Tokyo were quoted at prices higher than the price of the entire island of Manhattan in New York City. 


The real estate speculative mania eventually spilled over into the equity markets.  The Nikkei 225, representing the 225 biggest and best companies in Japan, was the envy of the world and everyone predicted that the market would rise far into the foreseeable future due to the formidable nature of Japanese business.  Like any bubble based on surreal fundamentals and irrational exuberance, however, the Nikkei 225 had a date with destiny in 1989.  The catastrophic crash of the blue-chip Japanese index from almost 40,000 to under 15,000 (where it STILL trades today, incidentally) is readily apparent in the graph above.  Like a ghost from the past, the ever present double volatility top signature made a special guest appearance in Japan.  The initial volatility spike culminated after the crash of the Nikkei.  The secondary top, as expected, did not occur until immediately after the bottom of the resultant bear market was reached!  Anyone else detect a pattern here?


We have observed a predictable intraday double volatility top signature identifying major bear market bottoms across eras, markets, and nations.  In every famous example of a crash followed by the usual bear market, the tell-tale double volatility top pattern emerges.  Why might they occur?  The answer is likely based on predictable human emotions…


All markets are cyclical.  The ultimate driver of general valuation levels is human emotions.  Anomalous overvaluations, or bubbles, are caused by raw naked investor greed.  As the prices of a particular type of investment began to rise, dollar signs cloud the eyes of those watching the markets, they begin to salivate like vultures at the “opportunities”, and after a few years EVERYONE wants to play the game.  The hype at a bubble peak is deafening, and the greed is so widespread and ingrained it is frightening. 


At the top of every bubble, after investments are trading orders of magnitude higher than their fundamentals would suggest they should, some catalytic event happens which galvanizes the crowd.  Like a stray gunshot on the prairie that causes a herd of cattle to begin stampeding, something transpires that turns the greed of investors into visceral fear.  While greed is slowly nurtured in the human heart over time, fear can suffocate greed in a matter of hours, stabbing like serrated daggers of frigid ice.  At the bubble top, some usually inconsequential catalyst virtually instantly morphs greed into fear, and a crash occurs.


As people sell in a panic, the market drops rapidly and daily volatility spikes up dramatically.  This initial fear based emotional sell-off is what causes crashes and what is directly responsible for the first volatility peak.


After the crash slows and stops, many investors are left stunned in a stage of disbelief.  They can’t believe they have lost 25% to 40% of their capital, and are shell-shocked similar to the way a soldier feels after his first battle.  Immediately the hypesters emerge from the woodwork like cockroaches, and begin to assure the naive and frightened general investors that all is well.  “The worst is over,” they claim.  “Nothing has changed, the best is yet to come!”  Or the five most dangerous words in investing, “This time it IS different.”  Gradually, the sharp daggers of fear quit poking the investors’ hearts and greed once again becomes the emotion of the day.  Yet, even as the masses begin to once again throw their hard-earned money at the deflating bubble, wise insiders are reading the writing on the wall and selling into every rally.


As time relentlessly marches forward, the market that was in a bubble state trends lower and lower, slowly trudging towards its ultimate destination of being fundamentally undervalued.  Slides in valuation over weeks and months occur, reaching new agonizing lows.  Yet, just as fear once again begins to elbow out greed, a visceral and sharp bear market rally occurs, and the flames of hope are once again violently rekindled in investors’ hearts.  The awesome bear rally, of course, fizzles out before it gets high enough to breach previous bear market tops, and once again the markets resume their slow tumble.


Like the infamous Chinese water torture, this grinding bear market eventually wears a festering wound in the defenses of the formerly bullish bubble participants.  At some point, after they have collectively lost 50% to 90% of their initial capital, they throw up their hands in despair and frustratingly concede defeat.  At that time, another catalyst occurs, and there is a final bout of capitulation selling.  After recovering 10% or so of their initial capital invested, the bubble investors swear to themselves that they will never again play the markets.  It is at this point that the bear market bottom is reached, when virtually everyone believes the markets will continue to drop and a bull is a long lost endangered species.  The second volatility top occurs shortly after the final bear market capitulation fire sales cease.


The signature bear market bottom double volatility top occurs because of predictable greed and fear that surround bubbles and busts.  Although markets and technology change, the human heart never will.  Greed and fear will ALWAYS drive cyclical over and then undervaluation, as long as humans exist and decide to participate in commerce and trading.


Armed with this historical and psychological perspective, how is the once majestic NASDAQ faring these days?  Have we seen a bottom, as bubblevision trumpets every single trading day, or is the worst yet to come?



Unfortunately for the eternally bullish NASDAQ fans, no double volatility top has yet been observed for the NASDAQ!  Even worse, unlike the 1987 crash which was officially manipulated at taxpayer expense into a full-on bull market, the NASDAQ is trending LOWER and following a normal bear market trajectory.  Until the characteristic double volatility top has been observed, we believe it is reckless and foolish to call a NASDAQ bottom.  With greed driving the NASDAQ bubble, fear driving its initial burst in March, and a surreal mixture of greed and fear percolating in the present while everyone tries to divine the NASDAQ’s next move, the index is so far matching a classical bear market profile perfectly.


To augment the ugly intraday volatility picture, a recent survey of individual investor sentiment exposed widespread investor OPTIMISM and bullishness on the NASDAQ.  Bear market bottoms are NEVER reached while popular sentiment on equities is bullish.  Only when virtually everyone invested in a particular asset class is overwhelmingly bearish and pulling out their hair do major bear market bottoms occur…  This is a very menacing omen for near and intermediate term NASDAQ performance.


Where is the ultimate NASDAQ bottom?  It is impossible to predict with any certainty, but the 100 day moving average of intraday volatility indicates that it is not yet in sight and is MUCH lower than 3000.  The NASDAQ perma-bulls have been wailing and gnashing their teeth because they have had a tough year.  We believe they ain’t seen nothin’ yet!


Adam Hamilton, CPA     November 17, 2000