Five years ago, any money manager at a cocktail party commenting on the Volatility Index (the VIX) would get blank stares. It was too far off the radar for most investors.
Flash forward five years and the VIX, also dubbed the “Fear Index,” is a permanent feature on CNBC. The average investor can track, leverage, or short the index with a variety of ETFs and ETNs. There are now separate volatility indices for oil and gold.
In other words, the secret is out. What was once off the radar is now tracked by investors looking for a warning sign in the market.
Right now, that warning sign is showing them that markets should see low volatility. The VIX has shaken off Europe’s debt woes, Japan’s natural and man-made disasters, and even the S&P’s downgrade warning for the United States this week. The last time the VIX was trading so low was in early 2007.
The VIX, however, has one huge problem. The volatility it tracks is based on the value of at-the-money options. It doesn’t take into account the fact that markets tend to suffer from extreme, largely unpredictable (or unthinkable) events, the “Black Swans” of finance.
A lesser known index, the SKEW index, looks at the volatility of out-of-the-money options.
When this volatility index rises, it’s because traders are expecting the higher possibility of a “fat tail” event occurring in markets, like the Russian debt crisis and the start of the housing bubble collapsing.
According to the CBOE, who designed the index, when the SKEW is at 100, there is absolutely no chance of a fat tail event. The index has averaged 115, with a range between 100 and 146.
One month ago, the SKEW was only at 120, somewhat close to its average. It’s been rising steadily since then, recently reaching 131.
That’s an alarming trend. The SKEW suggests that the risk of a major move in markets is increasing. It’s like a storm cloud on the horizon.
Meanwhile, the declining VIX suggests calm and blue skies ahead for markets.
But just because there’s conflicting data doesn’t mean investors should run for cover and completely cash out. There are always opportunities in the market.
The best opportunity for investors right now might be to shift from some of their best gainers and towards quality, cash-rich stocks.
Sometimes you’ve just got to move to defense from offense.
Whether it’s a full-on debt downgrade in the United States, another round of debt crisis in Europe, or a Fed policy gone awry, there’s certainly some risk in markets that isn’t being reflected by one of the better-known gauges.
Just remember: Volatility doesn’t mean a market crash per se. It means that markets will see more extreme day-to-day movements. Even when the market crashed in 2008, extreme down days often preceded extreme rallies.
So be prepared for the stock market ride to get a little wilder. But also be prepared to take advantage of the opportunities that ride presents.
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