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PATH FINANCIAL LLC
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Raul Elizalde - Thursday, February 24 2011
Machiavelli asked: Is it better to be feared or loved? Had he been an investment manager he might have said that it is better to fear the market than to love it. For our guard is always up when in fear, and usually down when in love. And we feel cheated when a two-day plunge wipes out 3% of our wealth when we thought we had little to fear.
In hindsight, everything makes sense. Tunisia and Egypt were minor, but Lybia is the largest oil producer in Africa. An uprising there inevitably creates a major upheaval in oil prices. Coming on the back of major increases in commodity prices across the board, one has to wonder why the impact on equities was not more severe. Of course, there is a possibility of more weakness ahead.
Was the equity reversal impossible to predict? One missed clue was the level of the VIX. The VIX is an index measuring the implied volatility of equity index options. While the mathematics may be opaque, the VIX represents the price that investors are willing to pay for stock price insurance. The higher the VIX, the more people want to pay to protect their portfolios. That’s why the VIX is also known as the “fear index”: people pay up for protection when they are scared.
During the worst days of the financial crisis the VIX reached exceedingly high values, but has been declining towards levels more in line with markets in rather normal states of moderate uncertainty. The curious thing is that in the last couple of months it reached exceedingly low levels, more similar to those of markets that have nothing to worry about. Considering how many issues remain unsolved – European debt, US deficits, Chinese currency, Middle East uprisings, etc. – one can hardly think of complacency as justified.
In December, and then again in January, the VIX reached a low around 15, the lowest since July 2007. Insurance was cheap, and this fact was accepted without much question – understandably so, since stocks had rallied almost 100% in about 20 months. But chartists have long maintained that once the VIX gets too low, the chances of a market plunge go up, especially when negative fundamentals simmer below the surface. A very low VIX implies that investors have let their guard down, and that creates ideal conditions for a reversal.
Another reason for the equity price decline of the last two days could be that, after a straight-line increase in stock prices – 25% since August 31, with barely a retracement – too many investors were sitting on too large paper gains. The opportunity to take some profits was too good to pass up. So some of the sharp falls could be due to profit-taking.
What next? The VIX, despite its recent spike, is still in a longer-term downtrend despite the jump from 15 to its current 22. In fact, at 22 it still roughly at its historical average. The thing to watch is whether it moves to a higher range: a VIX settling in the middle- to upper-20s would not signal good times ahead. It would rather suggest that investors have rediscovered fear, their guards are up, and will now be quicker to take profits or cut losses.
This is understandable, since the issues investors face right now are far more difficult to analyze than the US economy. A true seismic change in the Middle East would have an enormous impact on markets, but whether it would be positive or negative is at the moment unclear. There is no need yet to be pessimistic, but an extra measure of fear may serve investors well.
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We use quantitative measures to build and maintain portfolios for our clients, which we rebalance every quarter. We described our investment process in previous newsletters. If you would like to know more about how Path Financial’s investment process works, call us or send us an e-mail at the address below. We’ll be happy to set up a confidential meeting to discuss new paths to financial success.
Raul Elizalde | raul@pathfinancial.net | 941-350-7904
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