The Dow Shows No Fear

Although we don't believe in timing the market or panicking over daily movements, we do like to keep an eye on market changes -- just in case they're material to our investing thesis.

Investors often assume that when there's fear around the world, the stock market will reflect it by going down. Yet you also have to judge whether market participants actually take the public's fears seriously. Today, the Dow Jones Industrials (DJINDICES: ^DJI  ) have thus far showed no fear: The average rose more than 200 points earlier and was still up 185 points just before 2 p.m. EDT. The rise comes on expectations that lawmakers in Washington will agree to a deal that would avoid the potentially catastrophic impacts of a debt default, which could otherwise come as early as tomorrow.

Where's the fear?
By all measures, investors don't seem to be afraid of any potential problems from Washington's long stalemate. The S&P Volatility Index (VOLATILITYINDICES: ^VIX  ) plunged almost 20%, falling back to levels that prevailed before the shutdown began. Assuming a deal actually gets finalized, further declines in the so-called "Fear Index" could result.

That's bad news for investors in exchange-traded products that are geared toward protecting short-term protection against adverse market events. The iPath S&P 500 VIX Futures ETN (NYSEMKT: VXX  ) was down more than 10%, giving up all of its recent gains in the run-up to the shutdown. The leveraged VelocityShares Daily 2x VIX ST ETN (NASDAQ: TVIX  ) reacted much more sharply, falling almost 19% and coming close to setting a new 52-week low.

But one thing to remember about using market volatility as a measure of fear is that it doesn't match up perfectly. In general, the S&P Volatility Index rises when markets are falling, spiking upward on days when the market plunges. But these investments use different time frames for measuring fear. For instance, the iPath and VelocityShares exchange-traded notes both refer to futures contracts on the Fear Index, with time frames that look a month out. As a result, one-day events that might cause brief volatility but aren't expected to last long don't necessarily produce big jumps in the ETNs.

Moreover, the Volatility Index tracks movements in the entire market. For particular stocks, direct impacts can cause big jumps or plunges that won't show up in the overall index.

Protect yourself
Risk always exists in the stock market, and it doesn't fluctuate as much as the Volatility Index might make you think. For Dow investors, an arguably better way to handle risk is simply to understand that market drops will happen from time to time -- and to be ready to jump in and grab good bargains when they do.

Meanwhile, any short-term resolution to the debt-default threat still leaves open the long-term risk of huge amounts of government debt. The recent gridlock has awakened millions of Americans to the threat, but what can you do about it? The Motley Fool's new free report, "Everything You Need to Know About the National Debt," walks you through with step-by-step explanations about how the government spends your money, where it gets tax revenue from, the future of spending, and what a $16 trillion debt means for our future. Click here to read the full report!


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