How to profit from the return of fear
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Associate Editor
David Stevenson Jul 09, 2009
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Wall Street's "fear gauges" are waking up again. And they're rising at the same time – which means things could get extra-scary.
The VIX and CSFB indices are the US market's guide to investor jitters. So they're very closely watched by traders looking for signs that share indices are about to make a break – in either direction.
For the last few months there's been nothing much to get excited about – until now, that is. I'll explain what's happened in a moment, but suffice to say, the last time these two indicators coincided, there was a major market sell-off.
And being forewarned means that you could turn a very nice profit while everyone else is stricken with panic...
How to measure greed and fear...
When pundits talk about making buying and selling decisions based on stock market greed and fear, they often mean watching the way investors are behaving - and doing the opposite.
For example, you've probably heard the one about the great American industrialist John D Rockefeller. As the story goes, he sold out of Wall Street just before the 1929 Great Crash because he'd been offered share tips by a shoeshine boy. Rockefeller reckoned that if shoeshine boys were piling into the market, very soon there wouldn't be any buyers left.
That was greed. But what about fear? Assessing this in recent years has become much more technical – and the best indicators are in the US.
Firstly there's the VIX, officially known as the Chicago Board Options Exchange Volatility Index. This measures rising and falling levels of implied volatility priced into 30-day options on stocks traded on the S&P 500 index.
Translated into English, all this means is that the VIX judges how far the S&P 500 is likely to move, up or down, at any given time. The higher the VIX, the more fear there's supposed to be in the market. So as a rule of thumb, the VIX tends to rise as the S&P 500 falls, and vice versa (see Bloomberg chart below). The creator of the VIX, Professor Robert Whaley, says it is like "fire insurance – if there's reason to believe there's an arsonist in your neighbourhood, you're going to be willing to pay for more insurance".
Then there's the CSFB index, which is another insurance litmus test. It compares the premiums paid on call options – where buyers expect rising prices – with those paid on puts, where purchasers see prices falling. Again, this means that if investors are more worried that prices will drop than go up, the CSFB will be higher. A lower CSFB means that fears of a market fall have eased.
...and why this is useful for you
This may sound like something that should only interest technical traders. But don't switch off - even if you're not one of these, you could still find it very handy, for two reasons.
Here's the first. Trading website Sentiment's Edge – has just noticed something interesting. The VIX is near a six-month low, and the CSFB, by contrast, is close to a six-month high.
As Sentiment's Edge says: "there have been four other times during a bear market when we've seen a divergence like this. Over the next three months following those four instances, the S&P 500 averaged -9.2% [in other words, it fell by 9.2%], and with a risk that averaged more than six times greater than the average reward".
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Recently the market's longer-term downswing has been even more dramatic. The last time the VIX hit a major low while the CSFB topped out, back in May 2008, the S&P 500 stood at 1,400. By March this year it had more than halved, to its worst level in 12½ years.
Now I'm not saying history will exactly repeat itself. But there's plenty of scope for US stocks to retreat again after their second-quarter rally.
As we say in this week's magazine (out tomorrow - if you're not already a subscriber claim three free issues here) Russell Napier of CLSA reckons the recent stock rebound was just another in the long bear market that began in 2000. To his mind, even this year's March low didn't see any of the historic troughs in share valuations or the "revulsion against equities" – when investors just throw in the towel - needed for a real market bottom.
Which brings us to the second good bit. If you think that Wall Street is due a hefty sell-off, you don't need to be a PhD in advanced mathematics or option pricing to trade in the VIX.
There's a handy way of 'shorting' – i.e. selling with the aim of buying back later, thus profiting from any fall – the overall market called the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). Like the VIX, this tends to rise as the S&P 500 index falls and vice versa. It's like dealing in VIX futures contracts without the hassle because the fund does the work for you, for an annual management fee of 0.89%.
What are the risks?
What – other than the market rising, of course - are the risks? Both the VIX and VXX are priced in US dollars, so if sterling climbs against the dollar, you'd lose out. And in the unlikely event of the fund issuer Barclays iPath going bust, the fund could be suspended or de-listed.
Over the last three months, the VXX has tracked the VIX closely overall, though daily moves vary. Both have dropped over a third while the S&P 500 has risen by 30%. But in the previous six months when the S&P 500 dropped by 20%, the VXX jumped 14%.
The other point is that even if the S&P 500 doesn't fall that far, it only takes fear of an impending fall to push the VIX higher – so this is a good way to profit from traders getting an attack of the jitters.
And amid all the uncertainty, there are plenty of those around. As one US fund manager told Bloomberg earlier this week: "Too many people are thinking the worst is over… we're scratching our heads, going, 'Something doesn't feel right here.' It's probably better to have some insurance on the books." The more people who are thinking like that, the higher the VIX will rise.
Just before we go, if you haven't already heard, we're currently doing a great offer on a package which will get you both a MoneyWeek subscription and a subscription to all the investment newsletters written by our MoneyWeek contributors – but it's only open until 17th July, so you should check it out as soon as you can to see if it's for you. Find out more here.
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David Stevenson
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