What is the market’s ‘fear gauge’ telling us?

Did you know that the stock market has a ‘fear gauge’?

Not only that, but it’s fallen to a multi-year low – something some investors consider a signal to sell.

That’s because low fear means complacency is on the rise. Contrarian investors then consider doing the opposite, and panic a little!

I can understand that. Speaking from experience, it can be exciting to bet against the crowd. It can be profitable, too – there are definitely times when it pays to be a contrarian.

So is now one of them?

Well, let’s find out. Let’s start by looking at this particular indicator, and find out why it might be telling us to sell our shares.

Introducing the Vix index

The so-called ‘fear gauge’ I’m talking about is the Vix index. It’s an index that measures how volatile investors think the market is. In this case, ‘the market’ means the S&P 500.

Why’s it important what investors think about volatility? Well, sentiment is a vital influence on short term market moves.

But it’s very hard to pin down. Most of the time we just try and judge the mood of the investing public at large…

But the Vix gives us a number which quantifies how nervous people are feeling.

How? It’s actually quite simple. The Vix measures how cheap or expensive a certain kind of market insurance policy is.

When prices are high, investors expect trouble in the stock market and demand for insurance pushes up rates. When prices are low, on the other hand, few people are looking to insure against a plunge in the market.

It’s called a ‘put option’, and this is how it works.

The investor’s insurance policy

Imagine you’re worried about the market. There are two practical things you can do.

The most obvious is to sell your shares, but this can be a costly exercise, and if you’re wrong it can really hit your returns when the market carries on rising.

The alternative is to take out insurance through buying some ‘put options’.

Think of these like insurance policies. With a put option, you pay a premium to be protected against loss for a given period of time. If the market falls, your puts rise in value to offset your losses. If the bad event doesn’t happen and share prices stay buoyant, the puts expire worthless.

You’ve lost your premium, but you’ve benefited from holding on to your portfolio.

If you’ve got trouble visualising this, here’s an example of a put option in action.

Sell complacency, buy fear

As you might guess, put options were very dear in the aftermath of the Lehman Brothers failure and the onset of the financial crisis in 2008.

A Vix above 30 is generally associated with high volatility, while values below 20 usually mean less stressful times. But as the authorities battled to save the system in 2008, the Vix rose to 80.

Frightened investors were prepared to pay a lot of money to get insurance.

Yet only a year or so earlier, in early 2007, all seemed calm. The Vix stood at a lowly ten. Options were very cheap because everything in the garden looked rosy. No one wanted disaster insurance!

It’s easy to see from this how the Vix is a ‘contrary indicator’ – something investors use to help them do the opposite of what the crowd thinks.

If you sold in 2007 when it hit the low of ten, you avoided the carnage that followed. And when the Vix was up around 80 in the winter of 2008, that was a great time to buy.

The lesson? Sell complacency, and buy fear.

So what about this time?

So with the Vix trading around 12 at the moment, should we be going against the crowd and selling the market?

Possibly. But before you hit the sell button or load up on put options, let’s get a bit more context.

One problem with using the Vix like this is timing. Even in the extreme 2007-08 example you would have sold about eight months too early. You would also have watched in agony as the market dropped by a further 20% after you bought your shares back during late 2008.

It’s also important to think about the longer-term perspective. We’ve been through a truly exceptional period in the last 15 years which saw two savage bear markets.

If you think we’ve moved into a period where volatility won’t reach such extremes, then a lower value for the Vix will be perfectly normal. It won’t necessarily reflect complacency and would be misleading as a sell signal.

The verdict

The Vix isn’t something to rely on, but it’s certainly useful supporting evidence.

It’s a very handy way to quantify investor sentiment – and at the moment it’s saying investors aren’t that worried.

They might well be proved right, but it does no harm to be a little more careful for the time being.

This article is taken from our FREE penny share investment email Penny Sleuth.
Penny Sleuth is our FREE twice-weekly penny share investment email. Top penny share expert David Thornton will help you master the world of small cap investment. Each and every week he will pass on his simple, plain-talking insights and expertise that really could change your fortunes. Please enter a valid email address

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Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do

 

One Response

  1. 21/06/2014, MarcusByers wrote

    David,

    I want to buy the VIX. What is the most suitable method for this?

    Marcus

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