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Is the European Crisis Overblown?

The European debt problem has been a known issue for months now, but it has only blown into a full scale crisis since mid-april.  My own fear has been a bit tempered by the fact that European sales make up about 20% of S&P 500 revenues and the fact that the companies of the S&P are forecasted to earn about $80 in the coming year.  Even if you hack off a certain percentage for declining European demand, the earnings yield of the S&P 500 is in the 6-7% range while ten year treasuries are earning about 3.3%.  I realize that the market can move much further than fundamentals and that fear can drive prices much more dramatically than changes in growth prospects, but for now I still error on the side of opportunism rather than battening down the hatch while burying gold in my basement.

With that as the backdrop, I thought it would be interesting to look at VIX action along with previous crises of confidence.  As we can see, since 1995 the major dislocation came after the failure of Lehman Brothers in the midst of a pure freeze in the financial markets.  I realize that this could happen in Europe and spill over to the United States, but it seems unlikely to me given the government lending facilities that have been put in place.  You might say that governments are broke, but governments have printing presses and asset prices are valued in those fiat currencies.

The Great Recession stands out at nearly double the VIX level of all other modern financial crises

If you were trading or investing during any of these crises moments, then you would remember that the world seemed as if it would end.  Constant negative press with many predicting further drops of 20-30%.  The events of 2008 were horrid and it could be that 2010 is merely part two of the disaster.  I just have a hard time believing that because it takes a long time for a nation to become truly insolvent whereas a private banking system can freeze in an instant.

Significant equity declines combined with spikes of the VIX to about 45

A large part of the problem has to do with the events of May 6th.  The decline so far has not been significant in magnitude, but the speed of the decline on the 6th has left a lingering state of fear.  I would not be surprised to see the S&P 500 dip down to 1,000, but I do have a hard time imagining  that the VIX will spike to 80% as it did in 2008.  Regardless of this current decline’s magnitude, I am pretty confident that we will see the end of our crisis moment within the next 30 days.  During that time I will be willing to short volatility along the way and look for a buying opportunity when everyone confirms that the sky is falling.


 

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One Response

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  1. NGB says

    Hello, first of all thank you for your lessons about using VIX futures they have been very useful to me. I have a couple of comments regarding this issue:
    1. I couldn’t replicate your results of the VXX/VXZ paris trading from a couple of weeks ago. I also asked 2 independent friends and they got the same results. I only got 20% return over the covered period. I could send you my spreadsheet if you want. In any case the idea is valid and very clever.
    2. I have been studying the use of Variance futures instead of VIX futures, it appears to me that they are another good options, specially since they should reflex the “actual volatility” however it seems to me that the are not very liquid, could you comment on this topic?
    3. With VXX trading at around 32 and VXZ trading around 80 it seems to me that we could take te opposite trade of the one you proposed before, although I would be inclined to short VXZ outright.

    As usual thank you for sharing your knowledge



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