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Reading the VIX

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There have been an awful lot of big questions about the stock market being asked and answered recently. The uncertainty surrounding the election — not just the re-election of the president, but the party control of both the House and the Senate — has been resolved, but there is still a lot of concern over the resolution of the fiscal cliff, the looming budget cuts and tax hikes that have the potential to send the economy into another recession.

But even though the Standard & Poor’s 500 index has dropped about 6 percent over the past two months, and the index lost about 2.3 percent the day after election, investors have taken the whole thing in stride. There has been surprisingly little fear in the market, as measured by the VIX Volatility Index, which takes note of the volatility in the S&P 500. Also known as the fear index, it’s supposed to show how much uncertainty and risk there is in the market. And despite all the political turmoil, there’s very little fear out there right now.

In fact, earlier this week, the VIX dropped 10% in a single day, reaching a level of 16.68. That put the market’s so-called fear gauge at its lowest level in three weeks. Even on the day after Election Day, when the market slid, the VIX barely budged.

The long-term average for the VIX is around 20, but it generally soars above that when stocks are stumbling. Its high point for 2012 came in early June, when it reached 27; June 1st was also when the S&P reached its low point for the year. During the market’s extreme volatility in the summer of 2011, the VIX climbed as high as 40. So sitting under 20 is a significant change of affairs.

Even so, investors expect the current landscape to translate, at some point, into volatility. A recent survey from the financial publisher Ignites showed that eight out of ten financial advisors expect that fiscal cliff issues will drive up the market’s volatility. Three out of five advisors say the fiscal cliff is their primary post-election concern, and expect it to produce a heightened level of risk in the market.

The VIX roughly stands for the expected movement in the S&P 500 index over the coming 30-day period, converted into an annualized figure. So if the VIX is around 19, as it is right now, this means that investors should expect an annualized change of 19 percent in the S&P over the next 30 days. In the near term, that means an expected movement of around 5 percent over the next 30 days. When the VIX goes as high as 40, as it did last year, that indicates a change — in one direction or the other — of more than 11 percent in the next 30 days. That’s a frightening outlook, to be sure.

But it’s not necessarily bad news. The VIX is measured by weighing the prices of call and put options to assess what kind of swings investors are expecting. Any option can cost the writer if the market makes a substantial movement in either direction. It’s just as risky if the market goes up as if it goes down. So a higher VIX doesn’t mean that a bear market is on the way; it can also signal a strong upward movement.

One thing that is common, though, is that a selloff generally predicates a rise in the VIX. A downward plunge usually results in a fair amount of panicky selling, with investors eager to get out of the market. That drives the volatility index up.

Now, though, the election-day losses and the coming Fiscal Cliff issues haven’t resulted in greater volatility. At least they haven’t yet. And most financial pundits seem to think that the lower VIX is good news for investors. The smart money is definitely not panicking, and doesn’t see the market as especially dangerous.

On the other hand, many market watchers take investor sentiment as a contrarian indicator. When investors are at their calmest and most confident, that’s often taken as a sign that the market is near a bottom. Under that theory, the low-lying VIX could mean that people are overconfident about this market — and that it’s about to fall further.

Will that be the case now?  No one really knows. But it does suggest that whatever uncertainty remains from the recent elections won’t be any big deal for the stock market. That’s no surprise, since the White House, Senate and House all ended up not changing hands. And it further suggests that the fiscal cliff issues won’t significantly affect the markets. This also makes sense, since most observers simply expect the hard choices to be kicked further down the road.

In other words, it means the market is likely to be quiet for the time being. For spooked investors, that’s good news.

For more from Tom Nawrocki, see:

The November Effect

Q3 recap: 5 biggest losers on the S&P 500

The tales of 9 stocks that doubled


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