Montréal Exchange’s Implied Volatility Index (MVX) spiked on November 20th, 2008 at 80.68. Just as you would expect from a fear barometer. Spiking when bad economic news began rolling in and the S&P/TSX composite index plunged to 7,724 level, down 765 points on the day.

However, since then, the MVX has hovered between 40 and 50, still well above a previous fear threshold of 30, but well below its peak. And this at a time when the S&P/TSX composite index has not only failed to recover but has fallen below the November lows. Which raises the question; 1) has MVX lost its power to signal a selling climax? or 2) is MVX signaling that the market about to get a lot worse?

Historically, traders have looked at volatility as a fear gauge. In much the same way gold bugs look at the yellow metal as a safe haven in periods of market distress. But in this cycle, neither has reacted as one might expect given the precarious position of the financial markets.

Typically, we would expect the MVX to spike to new highs during periods of market capitulation. Because traders – presumably of the retail kind - buy puts to protect their positions, or to bet on further declines. Since retail investors are usually wrong at major turning points, Volatility indicators are seen as contrarian indicators… suggesting to option pros, that the best strategy is to write options during periods of high volatility.

Is it different this time? Possibly, if what we are seeing is a lack of interest on the part of traders to 1) pay up for downside protection (even with the MVX at 45, there is an associated high cost for that protection) or 2) are unwilling to speculate on further downside movement. The latter might normally be seen as a good sign, unless it is an indication of something more ominous… a buyers’ strike.

When you dig through the annals of history, the Great Depression of the 1930s was so bad, that it virtually eliminated a generation of market participants. Could we be witnessing a similar trend in the current environment? Could we be in the early stages of losing a new generation of market participants forever?

If that is the case, because traders have lost confidence in the system, this market may take years to recover. Just as it did after the great depression. Which would mean that the trillions of dollars sitting on the sidelines - as so many analysts have suggested – may stay there well after a recovery takes hold.

That scenario opens up yet another possibility for those who follow the volatility indicators. It is possible that we may see MVX rise during a market rally, assuming that rally lasts for a sustainable period of time… say anything over four hours. The result of professional traders – i.e. market makers or hedge fund managers – entering short positions during the rally.

Typically professional traders hedge their short positions, usually by purchasing calls to hedge their short stock, or through the purchase of puts in lieu of shorting the underlying. That buying power pushes up the cost of options, which implicitly means that the volatility implied in the contracts will rise, effectively increasing the MVX level. This would not be the typical spike in MVX one would see because of the willingness of small investors to pay any price to protect thir portfolio during a downturn.

If that scenario is the new norm, then volatility would no longer be a contrarian indicator - i.e. an indicator that by its action defines a market bottom - but rather, would become a coincident indicator. Which is to say an indicator that moves in tandem with the market. Rising when stocks are rising and falling when stocks decline.

What seems clear in all of this is that the universe “past” and universe “current” have very different characteristics. As Warren Buffet commented in his most recent letter to shareholders “Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the symbols. Our advice: Beware of geeks bearing formulas.”

If nothing else, assuming Volatility has lost some of its predictive value, it confirms yet again, that the financial markets are operating under a set of circumstances without precedence.