SuttonWatch.Net: Was There A Key Change In Market Volatility Last Week?

As mentioned previously in this column several times, I reside in Chicago, Illinois. More importantly, my home address is in the Hyde Park neighborhood where the University of Chicago dominates the landscape.

My path to Hyde Park is a story for another time, but I attended the University of Chicago Graduate School of Business between 1975 and 1977 where I was fortunate to earn a Masters in Business Administration. I never really appreciated the experiences I had back then until the last decade or so. Some of my legendary professors included Merton Miller, Myron Scholes, James Lorie, and Roger Ibbotson. Myron Scholes and Roger Ibbotson, in hindsight, were the most influential on my eventual career path (options trading, valuation, and securities research). Eugene Fama, the latest winner of the Novel Prize in Economics, was also teaching at the University of Chicago GSB when I was there between 1975 and 1977. While I never attended any of his classes, our paths crossed on the campus tennis courts one afternoon back then where we rallied a few minutes before our actual playing partners arrived at the courts. For both of us it was an insignificant moment in time, but our paths would cross again about 35 years later. For me, this 2nd crossing was monumental, but I am a bit sad to report that for Mr. Fama this second crossing was even less significant than our first crossing and not the least bit memorable for him (LOL). Such is life sometimes for the great unwashed when in the company of royalty!

My two children attended school (K-thru-12) with several of Eugene Fama's grandchildren, and my wife and I are friends with Beth Fama and Chicago Booth Professor John Cochrane who are Eugene Fama's daughter and son-in-law. We were invited to a party sponsored by the Fama-Cochrane's and I had a chance to "reconnect" with Eugene Fama in a short one-on-one conversation. I "re-introduced" myself to him, made small talk for only a moment or two, and then asked him the single most important question of my life. "Mr. Fama" I asked, "is volatility a meaningful factor in predicting stock prices?" Mr. Fama didn't hesitate with his response. "We've looked at that and the answer is NO", with emphasis on the "NO". There was no rebuttal expected from me and none offered. That was it. Conversation over. Verdict in. No discussion or appeal!

While I was not surprised at Mr. Fama's response, I will admit to hoping for at least a short follow-up discussion. But the window was closed, and we were in fact at a party where "business" discussions are frowned upon and sometimes not even proper etiquette.

For those of you who would blindly accept Mr. Eugene Fama's verdict regarding the relationship between volatility and stock prices, there is no need for you to read the rest of this column. After all, Mr. Fama is the deserving winner of the latest Nobel Prize in Economics. And if there was a "Hall of Fame" for academia, Eugene Fama would surely be among the first voted in. However, as incredible as it sounds, I think Mr. Fama's conclusion regarding volatility as a predictor of stock prices may be "less than 100% accurate". My humble research would suggest otherwise. At a bare minimum, volatility is an interesting tool for anyone foolish enough to attempt to forecast stock prices.

And for all those fools who might be inclined to listen to this fool, here's what I know and here's what I think it all means:

1. I believe that a major change in volatility is about to unfold across almost every market (stocks, bonds, commodities, and currencies). Please see chart below of current historical implied volatility for stocks and currencies.

2. The basis for this extraordinary claim is the significant uptick in actual volatility that was posted last week in the Gold and Silver markets.

3. Single-day volatility in Gold and Silver jumped to 23 and 38, respectively, last Thursday, June 19th. With a few exceptions, daily price volatility in both these key precious metals has been languishing between 2 and 10 this year so far.

4. 10-day volatility in Gold and Silver has jumped to 17 and 30, respectively, up from 5 and 7 respectively in early June 2014. Please see charts below.

5. A buy signal was triggered within my computer trading system in the closely-watch CBOE VIX Index on Friday, June 20th, despite the fact that the S&P 500 Index posted one of its lowest single-day volatilities on record at 2.40 for this same day! Please see charts below.

For argument sake, let's say that I am right in my prediction that a major increase in volatility is imminent. Since we are now near record lows in volatility, this prediction shouldn't be a surprise and may even be shared by many Wall Street analysts. The key question then becomes, what will a major increase in volatility mean to U.S. stock prices?

Bottom Line: A major increase in market volatility across all asset classes will probably be the direct result of a massive increase in "investor uncertainty" which will then quickly translate into sharply lower stock prices. In the interest of full disclosure, I am short the S&P 500 Index using the ProShares Ultra-Short SDS ETF in my managed accounts.