This note was originally published at 8am on April 24, 2013 for Hedgeye subscribers.
“Entropy is time’s arrow.”
That’s not a new reality. But it’s always an important one to remember. Arthur Eddington was the British astrophysicist who first called entropy “time’s arrow” in his 1927 book, The Nature of the Physical World.
You don’t have to be a physics guru to understand the concept of entropy. The 2nd law of thermodynamics calls entropy the price paid by an ecosystem when energy changes. I love applying that thought to markets – particularly when they are undergoing phase transitions.
“The rates of change of entropy differs for each specific event. All the while the rate of change of time itself is taken to be uniform, ceaseless, and non-negotiable.” (Chaisson, Cosmic Evolution, pg 31)
Back to the Global Macro Grind…
Moving fast, and slow. That’s what markets do. If you could have a signal to probability weight that the market’s entropy is about to change fast, you’d take it. Or at least I would. Some signals really matter.
One of the most basic relationships in a market is expected price versus volatility. The key word is expected. The two factors (price and volatility) have to be contextualized across multiple durations.
With those thoughts in mind, let’s look at the price of the SP500 vs front-month US Equity Volatility (VIX):
- SP500 is in a Bullish Formation (bullish TRADE, TREND, and TAIL)
- VIX is in a Bearish Formation (bearish TRADE, TREND, and TAIL)
Three days ago, points 1 and 2 were not true:
- SP500 was bearish TRADE (below 1557)
- VIX was bullish TRADE (above 14.82)
In between now and then, you were allowed to make a risk managed move (buy and/or cover) on the explicit signal (SPX breaking out, back above 1557, and VIX breaking down through 14.82). You were also allowed to ignore my signal. It’s a free world, sort of.
I rarely ignore my signal.
Obviously I am simplifying this basic relationship between expected price/volatility. I can front-run the gotcha guys who will say that using front-month VIX instead of the implied term-structure of volatility’s curve is a mistake. But why is it if the signal works?
Mixing theory with practice is a dangerous game. You don’t have to take my word for it on that – try it with your own money at home. Some have mathematical theories. Some have qualitative theories. There’s a lot of baggage in theories that don’t embrace change.
My sense is that consensus still isn’t bullish enough on the SP500. My sense is that consensus isn’t bearish enough on US Equity Volatility. But, to be clear, my senses aren’t based on how I feel. My sense is my signal.
What is the most probable path that consensus considers improbable this morning?
- SP500 going to 1603
- VIX dropping to 10.97
Do you disagree with that? Why?
On Thursday (last week) at 3PM EST here’s where the market was:
- SP500 = 1538
- VIX = 18.16
- SP500 = 1578
- VIX = 13.48
The context of this 3-day move (across durations) matters. Intermediate-term TREND support for the SP500 (1515) wasn’t violated on the downside inasmuch as intermediate-term TREND resistance for the VIX (18.89) didn’t break-out on the upside.
Should there be a difference between how you feel about a market when volatility drops 25% in a straight line? Should you make decisions based on feelings? Or should you re-model what’s becoming more or less probable for different expected price and volatility parameters?
I’m asking too many questions this morning. And I apologize for that. Maybe I should have just written a one sentence Early Look that said my model is signaling an up arrow for the SP500, and a down one for VIX to 1603 and 10.97, respectively.
Our immediate-term Risk Ranges for Gold, Oil (Brent), US Dollar, USD/YEN, UST 10yr Yield, VIX, and the SP500 are now $1286-1454, $96.68-104.06, $82.47-83.19, 97.27-101.31, 1.68-1.80%, 10.97-14.82, and 1557-1603, respectively.
Best of luck out there today,
Keith R. McCullough
Chief Executive Officer