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Decoding the ‘Wall of Worry’

David A. Janello, PhD, CFA

December 29, 2009

A stale market truism from many popular media pundits is that ‘bull-markets-climb-a-wall-of-worry’.

None of these commentators ever defines what a ‘wall-of-worry’ is, so the statement cannot be proved true or false. This is a convenient set of affairs for the glib commentator. It eliminates the need to define terms and to collect, analyze and interpret data. Not to mention the occasional need to fudge, falsify or even destroy evidence like the unfortunate climate change scientists at the University of East Anglia. We all hate it when that happens!

Let’s go out on a limb here and set a hard-and-fast definition: the ‘wall-of-worry’ is the CBOE Volatility Index (VIX). The name of the index is a bit misleading, for the VIX does not measure the actual volatility of stocks; rather, it measures the price of future volatility in the marketplace. It represents the consensus volatility level that market participants expect to see, backed up by cold, hard cash. By superimposing volatility levels vs. the directional moves of the S&P 500 Index, we can see in graphic format the ‘wall of worry’ alluded to by the pundits.

The 12-month graph presents a very typical pattern for extended bull-market moves that follow a market crash: as stocks go up, volatility goes down. The negative correlation between stock price direction and volatility is about 85%, which mathematically confirms the mirror image profile shown in the graph.

If ‘wall-of-worry’ is defined as market volatility, a more accurate statement is that ‘stocks climb a wall of receding worry.’ Or that ‘stocks climb a wall of increasing apathy’, which is another way of saying the same thing.

Looking at a longer 5-year time frame shows a more complex set of relationships than the trailing 1-year graph.

We see that the relationship between market direction and volatility was much more irregular and chaotic during the ‘normal’ 2004-2005 period than it was during the market crisis of 2008 and subsequent recovery in 2009. This is confirmed in the correlation numbers. The negative correlation was .76 in 2004 compared to the .84 in 2008 and .85 in 2009.

What can we learn by looking at these historic snapshots? Namely, that the ‘wall-of-worry’ exists in many forms and is dependent on the market regime. In relatively stable markets the relationship between volatility and direction tends to be more ambiguous. In explosive markets, fear and directional moves converge during the initial shock and also during the recovery period afterward. If and when we see the relationship between volatility and direction break down from the very stable pattern of the past year, it is a sign that the recovery is complete and a new market regime is set to begin.

Footnotes:

http://www.cboe.com/micro/vix/pricecharts.aspx