Volatility Soars As Stocks Plunge

03/01/2007 12:00 am EST

Focus:

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

Bernie Schaeffer, Chairman and CEO of Schaeffer’s Investment Research, analyzes the big spike in volatility that occurred with Tuesday’s sell-off and concludes that the US market isn’t as vulnerable as the bears think it is.

Tuesday proved to be a rough session for the market, as we finally saw the Standard & Poor’s 500 index (SPX) suffer the significant pullback that so many analysts were calling for. As a result, we saw both the CBOE Market Volatility Indices (VXO and VIX)spike sharply higher. (The VIX was up more than 60% on the day—Editor.)

Digging deeper, we find that the(VXO) increased by 68.3 percent on October 13, 1989, the day of the "mini-crash." The Dow Jones Industrial Average declined by 6.88% on that day. So, by all measures, it appears that yesterday's VXO/VIX rally was way out of proportion to the actual decline in the market. (The Dow was off 3.3% Tuesday—Editor.)

A bull could well argue that the implications of this “out of line” VXO/VIX gain indicate an overreaction and excessive fear relative to the extent of the damage to the market.

A bear might argue that the VXO/VIX was starting at extremely low levels, and thus, the move was "justified," that too many players were short premium and this is the kind of unwinding you get under those circumstances.

The "wild card" here has got to be the emerging markets. The iShares MSCI Emerging Markets Fund (EEM) was off by 8.13% Tuesday, so one could construct an argument that the VXO/VIX was reacting to the emerging markets meltdown as opposed to the more conservative move in the U.S. markets.

Bottom line, I'd have to conclude that the huge pop in VXO/VIX Tuesday is at best bullish and at worst neutral in its implications for the market. Here are some other points:

  1. All of the risk factors that were cited as causes for the market plunge—China, slowing economy (durable goods), sub-prime loans—have been beaten to death by the bears in recent months. Major market declines are almost always the result of unexpected events/developments.
  2. While the "sea of liquidity" that has supported the market might be in more jeopardy now, there is no reason to assume any fatal damage at this point.
  3. The percentage of analysts with "buy" recommendations on the S&P 500 stocks is near historical lows and is a far cry from the level of "buys" ahead of the 2000 market top.

We may have reached bubble levels in the emerging markets and in some commodities (I've been warning against investing in these sectors for quite some time), but the US stock market gives me no indication of being close to bubble territory. Contagion may create further downside in US stocks, but I would label such downside as "buying opportunity" and not "watch out below."

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