Thursday, October 23, 2008

The Volatility Index, the S&P500, and the Bubbles

I've posted a chart that shows the S&P500 vs. the VIX, or volatility index. The VIX is an index that represents the activity of option buying on the Chicago Board of Trade. This index is often referred to in the press as the "Fear Index". Without getting into the particulars, the VIX represents the option buying. The index trades at a higher price when option buying picks up, which is a sign that traders are trying to hedge away the risk of owning an asset (in this case, stocks.)

The S&P500 index is on the left, the VIX price is on the right. The picture tells everything, but some things to point out:

  • The VIX and the S&P are negatvely correlated. When one goes up, the other goes down
  • During the last Tech bubble ('99 - '02) the VIX had support at $20, but often traded up during the Bubble as traders worried that the IT companies like had no real earnings, or weren't worth more than GE...
  • The VIX peaked when the Tech bubble began to burst around end of 2001
  • The VIX then traded down heavily as the Fed eased rates and kept them low to stimulate the economy. All that really happened was 3 new asset Bubbles (Credit/Housing/Corporate Earnings)
  • The S&P peaked at ~1500 during both the Tech and recent bubble.
  • The VIX is currently at 70. In relative terms, this environment we're in is far from over, at least from a market sentiment point of view. Everytime you hear someone you someone say "the bottom has formed", keep you money in stable value for a bit longer. It's where I moved our money last July '07. Probably more luck than skill, but you know what they say.
This is the chart I've been staring at for the last 2 years. The 2 bubble peaks are undeniable. The VIX is just the market catching up with what was already apparent but no one wanted to acknowledge. Sometimes it takes you-know-what to stay on the sideline even though everyone else is drinking and dancing.

I think the bottom forms when the VIX starts to stabilize around 20-30, but just my opinion. I'm in capital preservation mode.