How Uncertain Is the Market Today?

Stipp: And what those range of outcomes might be.

Guziec: Exactly.

Stipp: So, obviously in the last nine months we have seen quite a bit of different sorts of volatility from what we were seeing last fall to what we have been seeing since March and then sort of where we are today, so how have you seen volatility kind of tracking the market's experience over the last nine months to a year?

Guziec: Well, we had some extreme uncertainty and some extreme implied volatility in some of the market convulsions in the fall and early spring. And that was primarily due to major sources of uncertainty: Will our banking system collapse? Are we going into the next Great Depression? These extreme, we have no idea how deep or how long the recession or depression will be. Everything is in a free fall. And when that is the case, it is very difficult to bound the answer.

Now we are looking at a different magnitude of uncertainty. We are asking questions like: when will the recession end? Will it be early 2010, late 2009, late 2010? Or how high will unemployment go, will it be 10% or 11%, 12%? Not will it be 20%.

We are not talking about: will this be an eight-year Great Depression? So we are more confident about our ability to bound those answers and that's reflected in the implied volatility measures in the market.

Stipp: So what are we seeing now compared to maybe a more normal period? So it is not as much implied volatility or market volatility as we saw last fall, but how about compared to a couple of years ago, before we sort of entered into the bear market, measuring it from then to now what are we seeing about the uncertainty right now?

Guziec: Well, uncertainty, let's use the VIX, because it is the most commonly discussed, it is the implied volatility of the front-month S&P 500 options. Typical long-run average is around 20%. In the Pollyanna scenario or the Goldilocks scenario of late 2006 it got down close to 10%. Right now we are at about 30%, so we are about 50% more uncertain than the average, although the VIX doesn't typically spend much time at its average, it tends to swing between the extremes, and we are down dramatically from peaks as high as 80% during the market crisis.

Stipp: OK. And speaking of the VIX, the VIX is often called the "fear gauge," but as you wrote recently in an article on Morningstar.com, that is really only telling half the story, so what is it, if it is more than a fear gauge?

Guziec: Well, it is a fear and greed gauge. It is a measure of uncertainty. Because of the relationships between put options and call options, when the put options get expensive, the call options get expensive as well. Sure, in times of uncertainty, markets tend to fall and implied volatility or uncertainty tends to rise, but you are looking at both upside and downside scenarios, because there is a fear that you are going to miss out on the upside as well. So it is not just buying insurance when your house is burning, there are people out there also buying houses in the neighborhood when they are cheap or trying to buy the option to buy houses when they are cheap, and the house next door looks like it is burning.

Stipp: So it is really capturing both of those.

Guziec: It is capturing both of those and sometimes you will see a market move to the upside and at the same time implied volatility arise and that's because people are saying, "Oh, the market is recovering, where is it going to recover to, how high is it going to go, what's the next good news coming down the pipe?" And that's where the greed gauge comes in as well.

Stipp: That's almost like "how good could it get" versus "how bad could it get" can also move the needle on that implied volatility.

Guziec: That's exactly right.