The Denial Index

The standard index and best way of measuring the volatility in the US stock market is the VIX.  (it’s an index of average implied volatility of listed options on the S&P of about 30 days expiry)

It is also known at the “Fear Index”.
But I think it should better be termed the “Denial Index”

When does VIX spike?

Volatility rises on negative shocks when stock markets drop rapidly.  This can be attributed to fear.  When the fear subsides, the stock market recovers, and the volatility drops.

This is where the index gets its name.

There are plenty of examples, take the equity market drop during 2015

Picture 1

Or the really huge drop during the financial crisis of 2008

Picture 2

The most recent sell-off also looks the same
i.e. the stock market drops and volatility rises.
So we can expect that volatility will drop again, when the market recovers.

Picture 3

If we look more closely at the examples, what we are really seeing is when there is a sharp drop in share prices, people do not believe it will last.  They do not accept that the new lower price is the correct one, and think that a rapid bounce back is likely.  What they are afraid of is that in the short term, the market will carry on going lower, but they do not expect that to last either.

In a real economic crisis, the fall in stock prices is for good reason and is here to stay.  Once the market reaches this level of acceptance, then we can have stock prices stay low, but volatility falls back to previous lower levels.  This is exactly what we saw in 2008/09.

Picture 4

If this crisis does turn out to be long lasting and real, as I currently expect, then we are still only in Stage 2  i.e. Awareness grows. Faith policy makers remains strong, even though the policy makers do not yet understand they are not in control. Markets believe it will be ok – e.g. positive reaction to Bear Sterns bail out.  (1st half of 2008)

The positive market reaction to the US stimulus package and Trump suggesting that the US be reopened is a sign that the market’s faith in policy makers remains strong.  The “Denial Index” still suggests that we expect these lower prices not to last and that a sustained recovery is imminent.  We will all find out if this faith is justified.


What would happen if Trump “reopened” the US?

The original strategy of the UK and it seems the current preference of Trump is that it is better to allow people to behave as normal.  There will be more deaths than the lockdown approach, but this it is argued that this is better than the alternative of a huge economic hit.

There is a similar and related idea that we might “shield” the elderly and vulnerable and allow everyone below the age of 65 to go back to work.  The economic/health trade-offs may be different at different ages.

I wanted to make some estimate of what the world might look like.  Please bear in mind that I have no expertise in this area and I very much hope I am very wrong, but my initial impression is that the results could be catastrophic.

The recent report from Imperial has been very influential in changing the UK government’s plan away from “herd immunity” (also known as “let the old people die”).

A key data table is below showing that mortality rates for people below 60 are very low.  This initially supports the idea that targeted isolation could be a sensible approach.

Picture 1

Their summary of the implication of the 2 paths is below:

  1. if all patients were able to be treated, we predict there would still be in the order of 250,000 deaths in GB, and 1.1-1.2 million in the US.
  1. In an unmitigated epidemic, we would predict approximately 510,000 deaths in GB and 2.2 million in the US, not accounting for the potential negative effects of health systems being overwhelmed on mortality. 

This to me seems quite compelling and explains the shift towards the “flatten the curve” approach the rest of the world is trying.

As an aside, a paper by an Oxford academic has got a lot of attention today as it suggests that half of the UK population might already have the virus and all will be ok.  I think this should not be taken too seriously.  Looking at the paper, it is a mathematical approach to build a parametric model where we have no idea what the parameters are.  This means that you can assume pretty much anything and thus get pretty much any answer.  Their description in the paper itself summarises why we should take no notice:

“Our overall approach rests on the assumption that only a very small proportion of the population is at risk of hospitalisable illness. “

If you have a mathematical model which starts by assuming that no one gets sick, it is not too surprising that the output result is that no one gets sick.  This type of analysis reminds me of mathematical economists during the 2008 crisis.  Utterly useless.
I wanted to take a different approach and go a little further and examine the age breakdown of the deaths, and possibly how we could estimate how the mortality rate changes if we do not flatten the curve.  It is here that I found the results most surprising.

I took the recent CDC study in the US, assumed a third of the population become symptomatic, and came up with a couple of ways of thinking about mortality rates in the population

  • Total deaths – version 1 (commonly seen in the press)
    Take the distribution of population by age and multiply by the current mortality rate of around 1% plus some estimate of how many people are infected
  • Total deaths – version 2
    Instead of the current mortality rate, estimate the mortality rate we would see in a crisis with the health service being overwhelmed.  For this, I took the number of patients requiring ICU as a proxy. 

The huge assumption I make in this very simplistic model is that, if the health service is overwhelmed, no one has access to ICU and all patients that required it will die (without intubation you cannot breathe).  This is obviously overly pessimistic as some patients will still have access to ICU and intubations will be taught to many more non-ICU doctors and nurses.  One the other hand my estimate of a third of the population becoming symptomatic I do not think is extreme.  The high resulting mortality rate is not something I would expect but it provides a useful examination of a worst-case scenario and we can explore the implications.


The number of deaths is shocking at 5.8 million

But it was the age distribution that initially surprised me because I had been fed so many numbers which are mortality RATES I had not been thinking of the absolute numbers.  Although the mortality rate of the old is much higher, the absolute number of old people is of course far lower.  Furthermore, it is the younger people who respond better to treatment (ie many more younger people are hospitalised but far fewer die.  If they cannot go to a hospital, we should not expect the same outcomes.

In this model, we have over 3 million Americans under the age of 65 dying from Coronavirus.

To be clear this is not a prediction.  This is not that sort of model.  It is an examination of the sort of impact we might see if we stop social distancing and go back to life as normal.

Stay home – stay safe




Is Coronavirus the new 2008?

I hope you are all staying safe at home.

I want to consider:

  • how safe are markets?
  • Is this yet another short term dip to buy?
  • A recession which we ride out with buying opportunities?
  • Or the early stages of a major crisis like 2008?

Life cycle of a major crisis – 2008

  1. Complacency and denial. (up to January 2008)
  2. Awareness grows. Faith in policy makers is strong, even though the policy makers do not yet understand they are not in control. Markets believe it will be ok – e.g. positive reaction to Bear Sterns bail out.  (1st half of 2008)
  3. Huge panic as it becomes clear that policy makers have no control (Lehman)
  4. Policy makers start to get a grip, but markets no longer believe them (late 08 early 09)
  5. Markets start to rise, albeit with a lag (Q2 2009)

Where are we in 2020?

Complacency and denial have been overwhelming until very recently.
Last 2 weeks have seen some growth in awareness (Stage 2) but there remains a lot of confidence that issues can be contained.  For the current market pricing to be correct we are either:

  1. Correctly pricing a normal recession
  2. Having a severe risk off event

Note that we are not pricing BOTH.  Perhaps we are not far from correct pricing for a recession, so there is not much leeway to argue there is an additional, large risk premium.  Therefore, I would argue we are in stage 2 (i.e. recognition that the event is real and has economic impact but no real panic)

Will we move to Stage 3?

Stage 3 is to be expected if there is contagion in financial markets (apologies that financial crises and pandemics have such similar terminology).  Examples include:

  • Major negative revenue shocks in corporates leads to credit concerns
  • Major negative revenue shock for individuals leads to credit concerns
  • The virus will last longer than expected e.g. into 2021

More broadly, what happened in 2008 was that a complex system fails in ways that cannot be predicted with precision.  Greenspan perhaps was correct that the 2008 crisis was “unforeseeable” in its exact details.  But what was obviously predictable was that the system would fail in ways that would surprise.  I do not think I had even heard of rehypothecation before 2008, but soon I had to become expert in it.  For coronavirus and its impact, we do not yet know what new things we will have to become an expert in.

My personal journey in this crisis was initially to be far more concerned than most people, but looking back still not nearly enough given how far reaching a pandemic’s impacts are.  I initially thought this would be a risk off event leading to a buying opportunity and was simply focused on preserving capital on the way down.   In hindsight this was a very tradeable event but it has unfolded far faster than the financial crisis and so you had to be very aggressive very early.

Now we have reached my original target of 2500, I feel I should not be in such a hurry to buy.  I am reminding myself that subprime did not destroy the financial system, it merely lit the fuse. Focusing too much on the details of the catalyst can blind us to the far more important second round effects.