Do The V’s Matter? Using Wrong Metrics

Have you been following the VIX? Do you know what it is? The VIX refers to the Chicago Board of Options Exchange S&P 500 Volatility Index. According to Bloomberg, “it reflects a market estimate of future volatility” for the stock market Or, in the words of Wikipedia, the VIX “is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis.” Notice that both definitions use either the word “estimate” or “expected.” This is (obviously) because nobody knows how volatile the S&P 500 will be going forward. The key point to understand, however, is that a higher value for the VIX means there is a higher degree of investor uncertainty in the market.

The VIX made an all-time closing high at 79.13 on October 24, 2008 as investors ran for the hills in the throes of the financial crisis. It fell after that and made a subsequent lower high at 57.36 on January 20, 2009. From then, it fell below 30 and stayed there up until a few weeks ago when on May 21st it spiked above 40 as fear of a European debt contagion spread. While off those recent highs, some fear appears to have returned to the market.

Volume on the New York Stock Exchange has been increasing too. Average daily volume over the past three years has been around 1.36 billion shares. The highest daily volume topped 3 billion shares on January 16, 2009. For the first quarter volume was below average running just above 1 billion shares a day. For the second quarter-to-date, volumes have jumped to around 1.375 billion shares daily.

The V’s are on the rise. Do the V’s matter? Do volatility and volume matter? They used to matter. Lots of data used to matter that have become warped and mangled by “high frequency trading (HFT)”. High Frequency Trading is not new. It used to be known as program trading and has been around for decades. Program trading added to the October 1987, Black Monday crash. But HFT has expanded. There are more practitioners, faster computers, and better algorithms to trigger trades. A statistic we read recently estimated the average holding period for a stock purchased on the NYSE today as 6 months! These HFT programs can execute hundreds of trades per day in staggering amounts with holding periods measured in minutes. The consensus estimates are that HFT comprises almost 60% of average daily volume. This tells us that 60% of a days trading activity is driven by mathematic formulae that are gaming intra-day price fluctuations.

In the old days of our youth in this business, my colleagues like Vince Farrell, David Kotok, Doug Kass, and I would find meaning in increasing or decreasing volume and volatility. Now, I’m not sure what we can discern. The volatility is exacerbated to ridiculous extremes such as we endured in May’s 1000 point ‘flash crash.’

HFT raises serious questions for serious investors: in light of the exaggerated and mangled short-term market metrics, what is the appropriate least-distorted metric against which long-term investors can judge risk, potential, and performance? And, are long-term benchmarks, which endure such volatility, still a valid measure for longer-horizoned, Buffetesque investors? Ultimately, how does one sort through the noise?

Our friend Doug Kass has been writing about the damage wrought by HFT. At the least, it undermines the confidence of fundamental long-term investors trying to do the right, responsible things for their retirements.

All of the short-term noise seems to be getting louder, and investors are yearning for a quiet moment to think and assess. Less sophisticated investors are always the most emotional. They test their “investment theories” daily and take solace or despair from the business section’s recap of yesterday’s movement. The ‘flash crash’ touched off a new, but to-be-expected, round of wailing and woe-is-me teeth gnashing. I’m really not sure how much weight to give to that strange day. Certainly it showed our country’s various trading platforms to be vulnerable.

When buffeted by noise, stick to your knitting. As the noise increases, increase your determination to adhere to your investment discipline and philosophy. Astute readers will glean from this market commentary that increased HFT and short-term orientation in the market actually create more opportunity for those of us who remain long-term investors. As markets moves go to extreme due to obsession with near-term results, opportunities are created for those who do our homework.

There are lots of investment philosophies out there, but most, if applied with dispassionate discipline, will result in success. Our investment discipline is steering us toward multi-national companies with solid balance sheets, strong cash flow, and improving earnings. We are dogged in the tenacious application of our discipline and philosophy. Over time, we expect to continue to be rewarded for our “Farr View.”