Fear Index

What a week for an investor while good news was being reported on the economy it did not matter as fear was the emotion of the week. Someone told me that they had an intuition in January and in early May that it was a good time to take profit. It appeared that he was correct on both accounts and this started me on a path of correlating this intuition to data.

My research showed that this intuition correlates with the VIX also known as the fear index. An inverse correlation exists with the value of the VIX with the stock market, the higher the VIX the lower the stock market. As the VIX rises the stock market goes down and vice versa. In the tug of war, that has been the subject of several newsletter, this measures the pull on the other fear side of the rope.

This newsletter will have 3 section, a recap from Vanguard, information on VIX, and how to invest using the VIX.

Vanguard Information

The nation's economic growth, which wasn't rising at record pace to begin with, appears to be slowing down. For the first time in more than a year, the Conference Board's index of leading indicators fell. But the news wasn't all negative. Minutes from the last Federal Open Market Committee meeting revealed confidence in the economy's recovery. According to reports on the latest wholesale and consumer prices, inflation shouldn't be a problem for the foreseeable future. There was good and bad news on the housing front as housing starts were up and building permits were down. The U.S. stock market continued to struggle. For the week, the S&P 500 Index fell 4.2% to about 1,088 (for a year-to-date total return—including price change plus dividends—of about -1.7%). The yield of the 10-year U.S. Treasury note fell 24 basis points to 3.20% (for a year-to-date decrease of 65 basis points).

Fear Index - VIX

VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options that was created about 20 yeaers ago. It is not backed by anything and positions held are merely a prediction of a future. A high value corresponds to a more volatile market and therefore more costly options, which can be used to defray risk from this volatility by selling options. Often referred to as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period.

Make Money with VIX

My underlying theory is that since investment firms only make money when people trade, buy or sell, trading opportunities must be created. So while an economic business cycle is the major market mover, investing cycles exist within the business cycle. For my theory to be true VIX values must be higher now than before, and this appears to be true.

The VIX value reached about 45 last week, quite a bit less than the all time record about 80 that was reached during 2008/2009. This means that while the past few weeks have been frustrating the amount of pain is not close to what we have been through. Next week, if the VIX continues to decline then the current positions should be maintained and if it goes above 45 it means that a more conservative approach would be warranted. A normal value would be around 20.

Getting back to this person's intuition, how does VIX correlate? By using a moving average approach, a time to take profits can be predicted using a 200 day moving average. A time to buy can be predicted by using a 65 day or 200 day moving average depending on risk tolerance. This strategy does not makes sense when VIX values are in a normal range. Taking profits based upon investment cycles makes sense for an IRA account since these trades have no tax implications and when to sell in a regular account when needing money in the short term.