Tuesday, May 19, 2009

Two Opposing Views on VIX

VIX, Chicago Board of Option Exchange Volatility Index, has broken below 30 today (ended at 28.80), despite the last half-hour dive of the major indices (DJI and S&P500) into red. The last time VIX was below 30 was September 15, 2008, when Lehman Brothers went bankrupt.

Today I ran into two different interpretation of lower VIX, one bearish, one bullish (if I may be so stereotypically speaking).

The first one is from Marketwatch.com titled "Is lack of fear such a good thing?"

The answer to this rhetorical question is no.

""The rally is losing momentum, which is not terribly surprising," said Ken Tower, chief market strategist at Quantitative Analysis Service. "Is the VIX dangerously low? I would say it's close."

"For contrarian investors, the fear gauge, when it reaches extreme levels, is seen as likely to pull back the other way much like an over-extended elastic. And it is therefore all the more fuel for a rally when it does.

"But now that the VIX has fallen back sharply, some analysts believe the pulse of the market is at risk of being too tepid and stocks might be facing another leg down. "

VIX is indeed often used as a contrarian indicator, along with put/call ratio and short interest (the higher the more bullish). Right now, put/call ratio is middle of nowhere, not high but not low either.

Here's the other view from Minyanville.com. Market bulls would love this...

In "Op-Ed: Investors Embrace Risk?", James Kostohryz, former head of international investment at a major Brazilian bank, says:

"The dramatic collapse of the VIX, first below 40 and now below 30, is a very strong indicator of sharply declining risk aversion. Based on this collapse of the VIX, and my interpretation of the historical data series, I believe that we will very soon see a collapse in another key indicator of risk aversion: cash allocations.

"Furthermore, history has shown that once the aforementioned risk preference indicators start trending, they exhibit strong persistence characteristics. This indicates that these indicators have a great deal more to run, and there's very limited risk that we're at the tail end of the trend in declining risk aversion. To the contrary, analysis of all of the indicators reveals that the decline in risk aversion is likely to persist and progress much further.

"In the face of the strong reversal of these risk-preference indicators, and the fact that the markets have likely only completed the first phase of a longer medium term trend, it's my contention that current cash allocation levels are unsustainable. "

Mr. Kostohryz thinks "Improving fundamentals + collapsing risk aversion + extremely high cash allocations = massive marginal cash inflows into equities".

I disagree with the very first component in the equation, though. I don't see any real improvement in fundamentals, and with the government spending like there's no tomorrow and standing ready to tax every single thing that exists, from cigarette butt onward, I don't see improvement coming any time soon. But if I modify it to say "Perception of improving fundamentals" (i.e. more smoke and mirror), then I tend to agree.

It happens to be my technical position also that the so-called "sucker's rally" hasn't suckered in enough investors yet. But I am nervous everyday that a sudden reversal of the market could happen out of the blue. Long or short the market, everyday is still a survival.


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