VIX and opportunities to buy

There is a new piece of data for me to keep track of now. As a former engineer I find it very difficult to pull myself away from a graph. The lure of relationship is so strong, but can be misleading.

After our recent “correction”, an index called the Volatility Index or VIX made the news - it is a measure of the volatility in prices of the S&P 500. (see formula above) It went over 20 last week which, based on recent historical values, is quite high. (Two charts above - first is 1986-present and second is 2004-present.) Basically, a VIX of 20 means that on average investors are calculating that the S&P 500 may change somewhere between +20 and -20% over the next month. The formula used to calculate the VIX is itself interesting (if beyond intuitive grasp), but the trends that can be extracted are very interesting. VIX is calculated throughout the trading day by the Chicago Board of Exchange and you can trade in VIX-options.

Look at the second graph with S&P data. Notice that, in general, the higher the VIX the greater tendency there is for a down trending S&P. This is especially true for values over 15. For some reason, peaks in volatility that do not surpass 15 do not tend to cause a depression in the S&P. In general, though, wide high's and low's tell us that stock prices are declining.

There are exceptions - notice the July 06 period where peaks in volatility followed, rather than coincided with, a precipitous drop in valuations and preceded a sustained upswing in the S&P. The Economist had a very interesting article in May of '06 concerning the very low levels of volatility in the market at the time and they refer to the VIX:

' ...on only eight days this year has the S&P 500 index moved by more than 1%, compared with 12 times a month in the wake of the dotcom bust, and 11 times a month during the great sell-off in the 1970s. Meanwhile, the VIX, which measures the share movements implied in stock index options, is at record lows. It predicts that the S&P 500 will move by less than 1%, up or down, over the next month.

VIX is alternatively known as the “fear gauge”, and all the signs are of an abnormally low level of anxiety among investors. There are plenty of reasons why they might feel unafraid. The world has enjoyed a long period of low inflationary growth, boringly predictable monetary policy and strong corporate earnings. Despite gently rising interest rates, there is still plenty of surplus cash to invest.

To stockmarket bears, however, low volatility is a warning sign: too much stability may, paradoxically, be destabilising. Ed Easterling of Crestmont Holdings, a Dallas investment firm, calls it “the calm before the storm”. He worries that speculators may have become overly complacent. “The current state of volatility is an indicator of potentially sharp stockmarket decline,” he says. '

http://www.economist.com/finance/displaystory.cfm?story_id=E1_GJNPDSN

The value of the VIX for investors has been written about extensively in the past. A very interesting article appeared in 2005 ( http://www.investmentu.com/IUEL/2005/20050729.html ) - they point out that 20 is the magic buying point. This is because the downtrend in values heralded by a rising VIX are very often followed by strong rallies. A review of earlier articles on the VIX ( http://www.topdownloads.net/guides/stockmutualfunds/vix_and_the_psychology_of_markets.php ) indicate 35 as the level rather than 20, however, the peaks and valleys of the VIX have declined over time. Both of these articles refer to the VIX as a sentiment level, i.e. some kind of emotional meter indicating that as the VIX rises and prices drop there are two things that occur. First, investors become more risk averse and second that investors act like cattle – moving as a group.

This latter point is very interesting for many reasons, but the most important reason for investors is that the movement of traders as “groups” suggests that the movement may not always be based on sound reasoning. Thus, while not preaching a “spit in the wind” approach, depression in valuations can be artificial, i.e. not based on fundamentals and therefore create a buying opportunity. This latest “correction” has demonstrated this, e.g. after the “fall” Apple could be had for the relatively cheap price of $83 and already stands at around $91.50. Indeed, with the exception of real estate and the financials involved in subprime lending, the majority of the market has rebounded to varying degrees.

Arthur Schlesinger

Arthur M. Schlesinger junior, historian and liberal, died on February 28th, aged 89.

A great liberal mind with a wit to boot. My highschool friends will remember having used his textbook in our American History class.

My favorite quote - In the past, when liberalism had resolved the crisis and restored tranquillity, conservatism has recovered power by the laws of political gravity; then it makes a new botch of things, and liberalism again must take over in the name of the nation.

New York Times Editorial

You have to scroll down abit to see the letter. I haven't had a letter to the editor published since I was a teenager. It was a bit fun! Just click on the title (link) above.

March 5-9 economic review

THE DIVE & the modest recovery - buying opportunity or a brief calm in the storm?

If your like me it was a bit confusing trying to figure out just what happend in late February. If anything it speaks to the herd mentality that seems to pervade Wall Street. Maybe its made a bit more "herd" like by automated trading. As best as I can see it, the sell-off began in Hong Kong when it was believed that the Government was about to begin cracking down on higher risk forms of investment. As the world turns so did the wave of selling. First in Europe then on Wall Street. Next came the denial by the Chinese Government - no crack down. Then came more explanations and everyones hero - Alan Greenspan - uttered the "R" word (even if qualified with "one-third chance"). Gentle Ben (Bernanke that is) then calmed things down with his reassuring words on the good feelings he had on the world economy. However, the rumblings continue to be felt, i.e. a certain uneasiness about the possibility of recession.

Why is that? Have corporate profits leveled off as Alan says they have? Is rising employment going to create a labor shortage thus pushing up wages? These two factors are believed by some to have been the catalyst of the internet bubble....ever rising wages further eatting into tight corporate profits made even more tight by increasing global competition and the inability of the New Economy to create the constantly increasing efficiencies needed to keep apace of rising wages.

If your like me I believe the sell-off was an anomaly and thus an opportunity to buy stocks on the cheap. If the modest recovery we've enjoyed is tell tale then the majority of investors seem to agree. However, there are alot of experts out there issuing warnings and being generally wary. (see one of my favorite columnists BUTTONWOOD in The Economist -http://www.economist.com/finance/displaystory.cfm?story_id=8829603)

CARRY TRADING
The rise of the yen relative to the dollar has lead some to move out of the carry trading business. Here one borrows money in a "weak" currency then purchases bonds or other instruments with a higher return in another currency (e.g. treasuries). The difference in return (e.g. 4.5% T-bill vs 0.1% Jp gvt bond) is the profit made by the speculator.

Many professional traders use this trade because the gains can become very large when leverage is taken into consideration. If the trader in our example uses a common leverage factor of 10:1, then she can stand to make a profit of 45%.

The big risk in a carry trade is the uncertainty of exchange rates. Using the example above, if the U.S. dollar were to fall in value relative to the Japanese yen, then the trader would run the risk of losing money. Also, these transactions are generally done with a lot of leverage, so a small movement in exchange rates can result in huge losses unless hedged appropriately.
ref:http://www.investopedia.com/terms/c/currencycarrytrade.asp