Volatility still at levels that accompany high risk
Measuring market volatility is one of the more commonly used methods to assess market risk. The presumption is that risk is much higher when the market is more volatile.
One tool used to measure risk is an index called the “VIX.” According to a description in Wikipedia, “VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. A high value corresponds to a more volatile market and therefore more costly options. … Often referred to as the fear index, it represents one measure of the market’s expectation of volatility over the next 30 day period.”
In other words, as traders anticipate higher volatility, the value of the VIX rises. The title of “fear index” results because high volatility causes fear or anxiety for traders and investors.
Below is a chart showing the level of VIX over the past five years. For most of 2005 and 2006—years that were fairly normal in terms of market volatility, the VIX spent most of its time hovering between 10 and 15. Volatility increased dramatically in 2007 and VIX twice peaked at higher than 30. In 2008 the VIX soared to a never before seen level of 80.
This year has been interesting. Many reports from the media and government sources are reporting that the recession is over and the economy is back on track. The S&P 500 so far has a double-digit gain for 2009. But in October the VIX again topped 30 and is even now hovering near 25. That is a sign that traders are still concerned about the risk and volatility of this market. VIX eclipsed its current level only twice in 2007—the second of those instances coincided with the beginning of the worst bear market in recent history.
Another simple way to examine market volatility is to simply compare monthly gains or losses of the S&P 500 over the past five years. As the chart below shows, monthly gains and losses over the past two years have exhibited dramatic swings when compared to the three previous years.
While March, April and May of 2009 produced three months of solid gains, many investors would not have been comfortable about being in the market during that period. A look at the VIX chart shows that while the VIX was dropping then, it did not fall below 30 until late summer.
Many investors have short memories. After a few months of market gains, the times of significant losses are easily forgotten. But successful lifetime investing is a marathon, not a sprint.
Right now many investors with money on the sidelines might feel that a rising market is leaving them behind. In reality, since July major stock indices have gained very little. In October the S&P 500 lost 2% and many technical indicators like relative strength are showing that positive momentum is failing. Bullish sentiment is at an extremely high level—something that usually occurs at market tops.
And as we have mentioned repeatedly, economic fundamentals such as unemployment simply do not support a continued major market rally.
Last week the government reported that the nation’s jobless rate reached 10.2% in October. This is only the second time in the post-World War II period that the rate surpassed 10 percent. In a speech this week, Janet Yellen, president of the Federal Reserve Bank of San Francisco, said: “With such a slow rebound, unemployment could well stay high for several years to come.”
In spite of all these negative factors, major stocks indices have staged a significant rally. This divergent advance could continue, or it could end tomorrow. Investors who take positions at this time need to do so with the understanding that by virtually any method of measurement, market risk remains at an abnormally high level.
F.S.