Volatility Mean Reversion and the Subprime Threat

Probably one of the best known anecdotes about stock market movement comes from the legendary financer J.P. Morgan whom, when he was asked once what stocks would do next is said to have replied: "they will fluctuate." This seemingly unhelpful reply has value for ETF investors today. Today's headlines are awash in speculation about massive general sell-off. For most investors panic at this point is almost certainly misplaced.

Analysts are warning of an impending U.S. and even world recession brought on by an imploding housing sector, a liquidity crunch, and uncontrolled losses at the big banks. Excessive use of leverage, excessive dependence on debt, a Fed unable to lower interest rates without risking inflation and a collapse of the dollar, and weak U.S. consumer demand are among the reasons given for why the market will not emerge from its tailspin. But equity ETFs and equity markets are not in freefall. Both equity and bond ETFs are in fact trading roughly where they were six months ago. Much has happened, but little has happened.

The first chart below shows key domestic equity benchmarks, the Standard and Poor Depositary Receipts (AMEX: - ) and the Nasdaq 100 Trust (Nasdaq: - ). The second chart below shows the 6-month returns of three key Treasury bond ETFs: the long bond iShares Lehman 20 Year Treasury (AMEX: - ), the iShares Lehman 7-10Year Treasury (AMEX: - ), and the short-term instrument, the iShares Lehman 1-3 Year Treasury (AMEX: - ).

As the charts above show, both benchmark equity ETFs and bond ETFs are trading approximately where they were six months ago, though their progress is inverted. Prices of Treasury Bond ETFs have advanced sharply since mid-June accelerating as the subprime mortgage crisis caught fire. Equities have sold. But this advance in Treasury ETFs followed several months of decline. And the sell-off in equities followed several months of advance.

The Volatility Index, or VIX, which measures the volatility of the ubiquitous S&P 500 tells this story. The chart below shows the 6-month VIX.

The VIX also known as the fear index spikes in times of fear and settle again as investors regain confidence. As the chart above shows, the VIX fell in March and stayed relatively low in April, May and June as the equities markets boomed. Fear pushed the VIX up again in mid-June, along with bond prices.

Volatility tends to be characterized by mean reversion, meaning that over the longer term values return to an historic average. This appears also to be happening with key ETF benchmarks, both in equities and fixed income. Now looks like a good time to be short volatility. Investors will also note that subsiding volatility (or fear) is typically concurrent with increasing asset values.

Of course, the mean reversion expected in volatility should not be confused with a reversion to a mean rate of return, which is important for valuation. In the case of the recent sell off, the financial sector for example may take longer that the broad market to recover. The chart below compares the SPY to the Financial Select Sector SPDR (AMEX: - )

But as the chart shows XLF is not so far behind the benchmank either. If interest rates come down, as they are now predicted to, this will be a benefit the financial companies hurting now disproportionately-- more than it will the general market. If this happens look for the return gap between the SPY and XLF to close.

Though it may indeed be difficult to find out what institutions are holding subprime debt (as Bill Gross and others have pointed out), the notion frequently espoused that the weakness in the subprime is limitless and that it is structural to the U.S. and even the global economy is almost certainly wrong. Total assets in the subprime market are about $500 billion. If half of these loans default, this still represents less than 5% of the $6.1 trillion in total outstanding loans (real-estate and other loans together) held by U.S. banks, and just over 1% of the approximately $14 trillion GDP. The S&L scandal of the 1980s by comparison also involved about $500 billion in assets, but in a time when U.S. GDP was only a third the size of today.

Okay, the next move in the markets is impossible to anticipate but (as J.P. Morgan noted) more volatility is certain. The end of summer and the beginning of the third quarter is immanent. As asset managers come back from vacations with a new look on things and an imperative to formulate strategies for the fall, volume will increase. The 9/11 anniversary is also approaching. All these events will likely bring volatility. But the longer volatility remains high, the more we can expect a reversion to the historic mean.

has specialized in short-term trading of equities and equity options since 1998. He is the author of a recent book on ETFs: ""