Fear Factor

On January 11 2010, though CBOE Volatility Index [VIX] dipped shortly under 17.00 mark it did close at 17.55 – the lowest level since May 2008. Right after Lehman Brothers bankruptcy and the demise of AIG, the VIX hit its historic high of 89.53 on October 24, 2008 on concerns about the banking system stability. Prior to this crisis, the VIX had peaked at 38 on August 8, 2002. By definition, the volatility index measures expectations of volatility, or fluctuations in price, of the S&P500 index. Higher values for the volatility index indicate that investors expect the value of the S&P500 to fluctuate wildly – up, down, or both – in the next 30 days. The index is also known as the “fear index” because a high VIX represents uncertainty about future prices. Warren Buffett once said “Sir Isaac Newton gave us three laws of motion, but his talents did not extend to investing. He lost a bundle in the South Sea Bubble, explaining later, “I can calculate the movement of the stars, but not the madness of men”. If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases.“

As we have seen in the chart above, there are times when movement of the VIX falls under the radar. Based on options activity on the S&P500, this widely watched gauge of fear and complacency among investors quietly declined, breaking the 20-point support level. A drop under this key point could basically mean that investors are becoming more complacent about the market. Moreover, a move toward 10-15 points could bring back memories of mid 2007 period, when credit spreads began widening while S&P500 index hit all-time high. If history repeats itself, this could very well mean a signal to reduce or completely square-off your long positions. According to recent data, investors are buying significantly more S&P call options than puts. Such exuberance suggests a high level of complacency, and a market correction becomes imminent.
With interest rates at historic lows in US, Europe and Japan, investors around the world are taking increasingly more risk, shifting large volume of capital from the more conservative fixed income markets to riskier equity markets, commodity markets or emerging markets. With easy access to cheap funding, global investment banks are reporting stellar quarterly earnings while ramping up the value-at-risk (VaR) numbers. By definition, VaR represents an estimate of how much an investment firm could lose in a single day from its trading portfolio. For instance, Goldman Sachs reported in the second quarter of 2009 that its value-at-risk had risen by 33% from the year-ago level, to $245 million.
Bottom line, it was only a matter of time until the current irrational exuberance will shake the markets. The humongous volume of liquidity that the Federal Reserve and its central bank counterparts have injected into world financial markets had to show up somewhere. Since the additional liquidity did not get into consumers’ hands, the effect will not be found in prices of homes or other large-ticket consumer goods. When this unparalleled liquidity dries-up, the VIX will rise again and simultaneously the stock market will go through a hefty correction.