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Volatility and fear plunge, but equity markets remain relatively stable.

The VIX, the CBOE Volatility Index, (also known as the "fear gauge") has been reduced roughly in half since late May – however, the major equity indices have eked out only small gains over that period.

Since May 20, when the VIX reached a 14-month high of 45.79, it has plunged to 22.63 as of the close on Tuesday. Meanwhile, the S&P 500 index climbed just 4.6 percent.

As an indication of investor sentiment, the VIX tends to rise and fall opposite the S&P 500. Therefore a declining VIX shows investors are getting optimistic as stock prices rise.

VIX uses the implied volatility of S&P 500 cash index options and is regarded as the market's expectations of volatility for the next thirty days.

Generally speaking, a low VIX suggests risks in the stock market are modest and share prices should trend higher.<br /> In contrast, when VIX is high, fear and market risk are correspondingly elevated and stock prices are expected to decline. (A VIX figure above 30 typically represents heightened fear in the marketplace).<br /> Given such a dramatic decline in stock market volatility (more than 100 percent) as we have witnessed over the past two-and-a-half months, one might have expected a healthier gain in equity prices.

But the modest rise in share prices (amidst an onslaught of disappointing economic data) may be suggesting something else &ndash; that the stock market is stabilizing.

Mark Arbeter, chief technical strategist at S&P, explained that May 20 represented the sixth day of an almost straight-line decline for the S&P 500 index, where it had lost about 100 points in that span.

"Dramatic increases in the VIX or option prices are a function of dramatic price declines in the market," he said.<br /> "The VIX does not lead the market because it is based on the volatility of stock prices. The S&P is higher since May 20, and the stock market has stabilized over the last couple months, so option premiums have declined and, therefore, the VIX is lower."

Ari Wald, an equity strategy research analyst at Brown Brothers Harriman, views the declining trend in the VIX as a sign of abating downside momentum.

"When the S&P 500 fell to its correction low in early July, the VIX held well below its May peak indicative of a 'less intense' low," he said.<br /> "Now, the VIX is back to its most complacent levels of the past three months, equaling levels that coincided with recent market pullbacks. We view this as a short-term sign of caution."

In terms of levels, Wald noted, the VIX has fallen near its 22 support each time the S&P 500 has traded up to its 1130 resistance.

"If the S&P 500 can break higher with a decisive downside break in the VIX, we would view this as a confirmation of strength," he added.

Jason Goepfert, president of Sentimentrader.com, said he could find only two other times when the VIX dropped 40 percent or more over a two-month period, while the S&P 500 rose less than 5 percent during that same period. Those were in early June 1994 and late December 2008.

"In 1994, stocks fell over the next few weeks, then formed a major bottom," he said. "In 2008, stocks fell for about two months, before forming a major bottom. There isn't much we can conclude from only two instances, but it does highlight how odd the current situation is."

However, Savita Subramanian, quantitative strategist at Bank of America-Merrill Lynch, has another explanation as to why the stocks have not surged in tandem with a plummeting VIX.<br /> "I think it's because the VIX isn't necessarily a true barometer of fear anymore -- it's a tradeable and manipulable instrument," she said.

Goepfert concurs that the VIX isn't necessarily a good measure of future expectations of fear, it is much more closely aligned with recent historical volatility.

"And stock volatility has been relatively muted over the past month, with a historical volatility of 24 percent" he noted. "That's not too far from where the VIX is."
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Publication:International Business Times - US ed.
Geographic Code:1USA
Date:Aug 4, 2010
Words:689
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