Historic fall in corporate earnings may bring "persistence of volatility" back from spring break

It may be tedious and unpopular, but earnings remain in a drop of historic magnitude. So any respite from volatility is likely to be short-lived, even if the bear market rally carries on to much higher levels over coming months. This post will not attempt to gauge how much more we might expect from the market's rally, but simply to get perspective on the economic backdrop and how it may relate to the volatility levels measured by the volatility index (VIX or VXO). The earnings decline seems to be even greater than that of the Great Depression - and volatility's high levels haven't yet lasted as long as comparable levels of that time. For all of us trying to figure out whether the Dow Jones Industrial Average or other equity markets can put the lows behind them and move on and only upward, this is a worrisome divergence. First, let's take a look at the comparison of earnings decline, courtesy of the 4/9/2009 public posting of "Chart of the Day":

Chart of the Day
Alcoa officially kicked off earnings season Tuesday after the close. Alcoa reported a loss of $497 million in the first quarter. For some perspective into the current earnings environment, today's chart compares S&P 500 earnings performance during the current economic recession (solid red line) to that of the last recession (dashed gold line) and the average recession from 1936-2006 (dashed blue line). As today's chart illustrates, the current decline in earnings is several orders of magnitude greater than the average decline during a recession. The current decline is also more severe than what was the most severe earnings decline on record – the decline that began in 2001 (gold dashed line).


"Webmasters, journalists, and bloggers may post an occasional free Chart of the Day on their website as long as the chart is unedited and full credit is given with a live link to Chart of the Day at http://www.chartoftheday.com/."

How does this compare to the volatility index, commonly measured by the VIX (also by the VXO and VXN)? Bill Luby shares some data on this in another good article, Persistence of Volatility (4/10/2009 at SeekingAlpha). Pointing out that the VIX finally dropped to its lowest level since September 2008, closing at $36.52 on Thursday, Bill reviews how this compares to the 1987 market crash. But then he compares to the Great Depression, a time frame we are more interested in - especially given the information shown above. He states: "Of course there are no implied volatility data going back to the Great Depression, but the 30 day historical volatility, a reasonable proxy for the VIX, was able to remain above the 30 level for 16 long months from September 1931 to January 1933. If the VIX stays above 30 through Memorial Day, that will mark the halfway point of the 1931-1933 record."

Unless the bear market rally skyrockets to "irrational exuberance" levels (as Raymond Merriman mentions is possible, from a sentiment standpoint as described in his weekly preview comments posted earlier this morning here), it's difficult to believe that the VIX will drop under 30. It's interesting that smaller, individual traders have become able to buy and sell VIX-based securities, and I do tend to wonder how much that may have contributed toward the VIX actually declining (showing a sort of complacency divergence with the equities markets). But at some point, whenever the equities rally is over and done (which can take months so we'll see), it's reasonable to think that the volatility index will embark on another path to new heights.

Below are my volatility index charts that include trendlines and some comments and Fibonacci ratios. First is the ratio chart, SPX:VXO, which gives a neat visual depiction of the strength of the S&P 500 index rise relative to the decline in volatility. I've been wondering for weeks if it would want to test its 200-day moving average, and am fascinating to see that it rather looks that way. If it gets there, I'll be similarly curious to see whether that level helps provide the catalyst for a reaction there. Then my other volatility index charts, including the VIX chart that's been carrying a comment for many, many weeks now about the 35 and the 33/34 levels being a possible target ... and the VIX is almost there. As for why the VIX would decline to these noteworthy levels during this time frame, even in the light of lousy earnings data as shown by "Chart of the Day" - I've noted before that the Economic Confidence Model of Martin A. Armstrong seems to correlate well with turning time frames for the volatility inex. Given that we're moving into that model's time window for an interim high, perhaps we really should not be surprised that VIX is dropping into this time! And then, we might be thinking that it's just a matter of - time - until the confident feeling pulls back enough for the ugly economic realities to affect market and index prices once again.