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.