It’s time to be fearful – investors aren’t frightened anymore

Investing is and should be simple. But it’s not easy.

The simplest way to make money is to buy things when they are cheap and sell them when they are expensive. Unfortunately, most investors just don’t do this. In fact they make life difficult for themselves, and tend to do the exact opposite – chasing the market when it is going up, only to panic and sell after it has gone down a lot. Consequently, these people don’t tend to make a lot of money.

But how on earth can you work out the mood of the markets? Well, like lots of things when it comes to money, we can look to America and something called the ‘Vix index’.

The investor’s fear gauge

What happens on Wall Street tends to set the tone for what happens across most of the world’s stock markets. So knowing the mood of US investors could be quite useful.

The Vix is a measure of risk. It is an expectation of how much future share prices – in this case the value of the S&P 500 index – are expected to bounce around; how volatile they might be.

The value of the Vix is worked out by looking at the price people are willing to pay for the option to buy and sell the S&P 500 in the future. These prices are known as premiums. The bigger the perceived risks, the higher the premium investors are willing to pay. The Vix then takes a weighted average of all the premiums out there and comes up with a number.

But what does this number actually mean?

Let’s say that the Vix is 10. What this means is that the value of the S&P 500 is expected to move up or down by 10% for around two thirds of the time (or one standard deviation) during the next year. Big wild swings are unnerving for most people, so low Vix numbers are often seen as a sign that all is well.

As a rough rule of thumb, the bigger the Vix number the more fearful investors are. As the Vix heads above 30, investors are seen as becoming more nervous. Below 20 and they are fairly relaxed about life, maybe too much so.

Yet you should probably worry more about a low Vix number. A low number says that investors aren’t worrying much. In fact, they may have become very overconfident, complacent or greedy. This often means that trouble isn’t far away.

The Vix from mid-2007

Vix gauge

Despite warnings about reckless lending and a frothy housing market, the Vix showed that there was little fear amongst investors during 2007 and much of 2008. Then the financial crisis hit, and the Vix spiked as high as 80 in October 2008. It then calmed down, spiking up a few more times, but is now very subdued.

Vix v the S&P 500 index

Vix gauge v S&P 500 index

As you can see, the Vix and the value of the US stock market tend to move in opposite directions to each other. Big spikes in the Vix match up with falls in the market. Since the end of 2011 the Vix has kept on falling whilst the S&P 500 has risen to a record high.

A sense of deja vu

Now the Vix stands at just over 11 – a very low number. It’s telling us that stock market investors aren’t expecting any wild upwards or downwards swings any time soon. Some commentators argue that investors have become too complacent, and that this is a dangerous sign.

It’s hard to disagree with this view. Lots of things look eerily similar to what was going on before the financial crisis. The stock market is in buoyant mood with valuations – especially the cyclically adjusted p/e (CAPE) ratio – looking rather frothy. In the UK, the housing market is glowing red hot with affordability becoming more and more stretched at a time when people’s wages are hardly growing.

And then there’s the fact that the smart money – particularly private equity – is selling up just as it did before the last crash. The stock market is flooded with IPOs from private equity owners selling their businesses for very high prices. This is a classic sign of a stock market that is near its top.  Over 50 years ago legendary value investor, Ben Graham, had this to say about IPOs and the value of the stock market:

“As the market rise continues, this brand of financing becomes more frequent; the quality of the companies becomes steadily poorer; the prices asked and obtained verge on the exorbitant. One fairly dependable sign of the approaching end of a bull swing is the fact that new common stocks of small and nondescript companies are offered at prices somewhat higher than the current level for many medium sized companies with a long market history.” –  The Intelligent Investor

I’d say that pretty much sums up what’s been going on recently.

But more worrying than anything else is the ever-growing view that shares are the only viable option for investors these days. Low interest rates on savings accounts and bonds have forced many people into the stock market, helping to push its value up.

Yet it’s easy to forget that sound investing is about not losing money first and foremost. Interest rates will not go down from here. When they go up, the dividend yields on shares will not look as tempting and there’s a good chance that share prices might lose some of their recently acquired fizz.

Granted, central bankers are frightened stiff of another financial crash happening, and will not take the drinks away – by raising interest rates – from this party in a hurry. Wall Street and the City know this, and so markets could keep on going up for a while.

However, if you have just topped up your Isa account to take advantage of the new £15,000 allowance, you might just want to check a barometer like the Vix before you invest your money. It’s not raining on the markets yet, but it looks like the clouds are gathering.