Vexed by the Vix!

Market Shows Little Fear.  Time to Be Worried?

The CBOE Volatility Index, otherwise known as “the Vix”, is commonly referred to as the fear index as it measures the market’s expectation of volatility using S&P 500 index options.  Generally speaking, the value of the Vix at any given moment is the amount that the market thinks the S&P 500 can rise or fall over the next 30 days.

While the Vix (VXX, VXZ) can measure uncertainty over market gains or losses, it is typically associated with bear markets, as investor psychology tends to worsen when the market is falling as opposed to rising.  To see proof of this, look no further back to October of 2008 when the stock markets were collapsing during the height of the credit crisis.  It was at that point that the Vix reached its highest levels by far, and justifiably so.

Since that time, the equities markets have rebounded from their March lows, and the Vix has returned “to earth” from its stratospheric levels of last October.  But has it come back too far?  Is this Vix telling us that we’ve now returned to reasonable levels of uncertainty, and that market conditions have stabilized?

There are two major reasons why the equity market should be more “fearful” than it is right now.

“Strong Dollar Policy”. In what has become somewhat of a running joke, the Fed’s stance that the U.S. has a strong dollar policy despite having record low interest rates, quantitative easing programs which probably should show negative interest rates were it possible, and ballooning deficits is the greatest threat to market stability. Especially when you see headlines like this 5">one.

One of the reasons why the equity markets seem to be shrugging off this news is because a weak dollar has been good for the equity and commodity markets.  A quick look at this chart shows the inverse correlation between the US dollar (UUP) and the S&P 500 Index (SPY).

So as long as Bernanke keeps on printing dollars, the markets should continue to go up, right?

While this scenario is highly unlikely, the only way to prevent this from happening is for the Fed to raise interest rates.  And while they are loathe to do so in the face of rising unemployment, pretty soon the tactic of jaw-boning of the dollar higher will no longer work and they will not be able to control the massive sell-off.  This leads to the second scenario which should cause fear in the equity markets.

A rising interest rate environment. It is become apparent that Bernanke is running out of time and there are too many holes in the dam for him to plug.  To think that he is going to be able to control inflation and dollar devaluation when he does decide it matters by raising interest rates 25 bp at a clip is naïve.   Once the ball gets rolling, he will have to take drastic action and this could mean major rate hikes.  Thus we would see a move out of equities and into bonds, which could also derail the gains in the stock market and could push us towards the dreaded ‘W’ market recovery.

Either way you slice it; these are two “doomsday” scenarios which could have major negative implications for the stock market.  Investors and traders alike will have short memories this time and rush for the door at the first sign of panic, which will in turn help move the market lower.

This brings me back to the current level of the Vix, which is sitting somewhere around 22.5 at the time of this writing.  If the high of the Vix reading was 89.53 last October, then shouldn’t it be higher considering all of the negative factors facing the market?

Yep I thought so too.