The “Fear” Index falls back to historic lows

The Chicago Board Options Exchange VIX index, which is based upon the  S&P 500 options contracts volatility component and which is often used as a measure of equity volatility has fallen this in the early part of this year back towards six year lows. Yesterday it closed at 12.46.

The index recorded its lowest level this year on January 22 at 12.43 and is now trading at a similar value to that last seen in April 2007 – ominously just before the GFC swept over the globe. Since hitting a record high near 80.86 at the peak of the financial crisis, in November 2008, the VIX has been falling consistently, especially during the last few months, as retail investors rebuild trust in the stock market and investors are pushed out of bonds by Mr “Helicopter” Ben Bernanke.

The volatility index actually fell 23% last year, most of the drop occurring after QE3 was announced and it is now registering a 30% drop this year. With the S&P 500 just 2.2% below its record close held at 1,565,15 and hit on October 9, 2007 and the Dow only 0.9% below its all time high, it is no surprise the VIX is so low.

After pulling almost $300 billion out of stock funds in the aftermath of the financial crisis, investors have pumped in $37 billion in January alone, a level of cash commitment by retails that not seen since 2004 and which clearly shows a change from “fear” and  a defensive stance with all the bond fund purchasing, to a more willingness to accept risk. The major change in investor sentiment came after Ben Bernanke and the US Federal Reserve announced the QE3 package in September of last year and with the FED continuing to add monetary fuel to the fire with an additional $45 bn asset purchase program to substitute for the now ended “Operation Twist”. The FED’s additional commitment to pursue the program until the unemployment rate is around 6.5% seems to have been the green light for investors to step on the risk pedal.

Red – VIX index / Blue – S&P 500

Not only has the VIX been dropping but also price swings in the market are very narrow, in fact the narrowest since 1995 and which of course explains in part the low VIX measure. Whilst during the past five years the average daily price change observed in the S&P 500 was around 1.08 percent, since the new year started, price swings dropped to 0.43%, less than half its five year average. Interestingly, according to Bloomberg, stocks have gained an average of 17% in the year when price swings are that low.

A drop in volatility is always a signal that fear is receding and that investors are willing to accept the higher risk that equities carry but, we shouldn’t forget that the current values are similar to what was observed in the pre-crisis period. Just a few months later we entered a bearish period when most equity indices saw their value halved… While low volatility may seem comfortable to equity market participants, it coincides typically more with a peak than with a bottom, especially when we reflecting upon the fact that we are now entering the fifth year of the current bullish run. We also have to consider one important bearish argument here which relates to the FED. With the US economy recovering and with the FED balance sheet in the trillions, we must prepare for a sooner-than-expected end to QE3. When that happens, markets may suffer.

Adding to the bullish case though, we still have a S&P showing a P/E ratio of 15, which is more than 9% below its average of 16.4 since 1950. There are many stocks with conservative valuations such as Apple. At this point, we think the best strategy is not to buy the whole market but rather to be more selective with stocks. Buying the whole market was the best strategy at the start of this bullish run, not now.

Take a look at our guide below if you’d like to read more about the characteristics of typical bull runs and when the next one may end.