Quantifying Ambiguity – the New Frontier for Predicting Stock Market Behavior

Something is missing. Analysts and market observers all see the obvious. This bull market is long in the tooth and investors know it. Yet volatility, a supposed measure of risk, as reflected in the CBOE’s VIX index, is near record low levels. The VIX presumption has always been that, as fear levels increase, stock prices will decline in some sort of related pattern. This is not happening. Widely growing uncertainty is simply not being reflected in the VIX or the markets. Why?

Menachem Brenner, an early developer of the VIX and a professor at NYU’s Stern School of Business, believes that the VIX is low because it doesn’t measure the ambiguity inherent in uncertainty. We know from data that the risks and returns of diversified securities portfolios asset-allocated according to standard deviation and covariance guidelines are reasonably predictable over ten-year periods. But, for periods less than five years, there is little confidence that investment results can be predicted. Because the VIX is a short-term indicator (30-days) and further, does not appear to be able to account for market uncertainty, is it really useful for analyzing and predicting market behavior? Is there something else better? The answer is the focus of Professor Brenner and Yehuda Izhakian, a professor at Baruch College.

The professors define ambiguity as the measure of the degree of confidence investors have in the probabilities they use to make decisions. So, while the VIX is accurately able to measure historical data like standard deviation and covariance, it is altogether unable to measure either high or low confidence levels in those probabilities, information critical to predicting future activity. Professor Brenner views volatility as measuring the “known unknowns,” or the uncertainties about which one can measure probability, while ambiguity reflects the “unknown unknowns,” where the probabilities themselves are a mystery.

When I recently read about the professors’ theories in a WSJ article by Ben Eisen, an imaginary but loud bell started ringing in my ears. Before the devastating market breaks in both 2001 and 2007-2008, “we” all knew the market was a time-bomb; but instead of flattening or correcting, it kept climbing – at an even quicker pace. All the players wondered, should we sell and miss short-term profits or stay in? I exited before the sell-off, but most were not so timely. What was the probabilities data not showing? Undoubtedly, the professors would say it was the unmeasurable lack of confidence in the probabilities themselves.

Professors Brenner and Izhakian are working to solve this problem. Their goal is to quantify ambiguity so that it can become a trading tool like the VIX. So far, they’ve been able to conclude that risk and ambiguity together have a positive relationship with market returns by showing spikes ahead of the U.S. financial crisis and the European debt crisis. Next, they hope to devise a real-time gauge offering a market signal to investors that can be quoted in real time, like the VIX.

The professors are modest about the potential audience for the tool they hope to create; but from this market participant’s experience, they may be after the gold ring. I hope they find it

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