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Greed Isn't Always Good, Part 2
"Investor beware," we cautioned on May 23 - just one trading day after the S&P 500 Index hit the record high from which it has been slipping ever since. "Fear is in a bear market," we warned, "and that can be a very scary thing."
Right on cue, the stock market started falling... and it hasn't stopped falling yet.
But now that the major U.S. market averages have plummeted 10% or more in just four trading sessions, the "bear market in fear" has clearly ended... and a new bull market in fear has begun. What does this change of sentiment portend for our battered and bruised stock market?
Let's ask the VIX Index - aka "Fear Gauge" - for some clues. But first, let's get some background details...
As we explained in our May 23 observation, "When investors lack fear, they also lack caution... and when they lack caution, they take risks. The longer those risks pay off, the more invulnerable they feel... until, eventually, the stock market reminds them that risk-taking hurts sometimes. That's when investors rediscover fear, if not abject terror, as share prices fall."
We issued these words of warning because the VIX Index had just dipped close to its lowest reading of the previous two decades, which was a sign that investors had become dangerously complacent.
"Extreme low [VIX] readings tend to coincide with important market peaks," we remarked. "During yesterday's trading session [May 22], as the S&P 500 Index surged toward another new record high, the VIX Index dropped to 11.82... [which is among] the lowest 5% of all daily VIX readings of the last 20 years. A reading this low is no guarantee that the stock market will take a tumble; it is merely a hint that the risk of a major decline is higher than average.
"The VIX could easily continue falling," we conceded, "[but] since 2007, the S&P 500 has fallen an average of 21.2% one year after VIX readings below 15.5."
Therefore, given the sell-off we thought likely, we provided the list below of VIX ETFs and ETNs for investors to consider if they wished to bet on a market decline, or if they wanted to hedge a portion of their portfolios.
Since May 23, the short-term futures funds in the table have soared about 30%, while the mid-term futures funds have gained about 7%.
So much for the recent past. What about the immediate future? What does today's much higher VIX reading indicate about imminent stock market trends?
Well, the "good news" is that stocks fell so fast and furiously yesterday that the VIX soared to its highest reading since the market washout of 2008! Based on recent historical tendencies, therefore, the stock market should be close to making a low. But there's a catch...
Prior to yesterday's pyrotechnics, the VIX had vaulted above the 45-level only seven times in its history. The table below shows how the market performed during the six months that followed each of those instances. As you can see, the market moved higher on six of the seven occasions without suffering much of a setback along the way.
On average, not including 2008, the S&P 500 rose 16% during the six months following a 45-reading, without falling more than an average of 4% en route to those gains. In other words, a 45-reading on the VIX has been a pretty darn good "Buy" signal... most of the time.
But there's one itty-bitty fly in the ointment. The 2008 experience shows that the VIX could continue soaring higher as the stock market drops even lower.
Bottom line: Volatile markets are dangerous markets. They aren't for widows and orphans, as the saying goes. So the best course of action at the moment is probably no action at all... until the volatility subsides.
It's true that patience might prevent you from catching the exact bottom of this sell-off. But patience might also prevent you from "catching a falling knife."
Remember, risking capital is optional.
Cheers,
Eric J. Fry
For The Non-Dollar Report
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