Investors Have Declared the Dow Pullback Over

With the tone of the Fed's message firmly in place, investors have their complacency back. Will it last?

Feb 11, 2014 at 12:30PM

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.

The Dow Jones Industrials (DJINDICES:^DJI) are celebrating Tuesday, rising 144 points as of 12:30 p.m. EST after the latest word on Federal Reserve policy remained much the same, if not even more accommodative, on the monetary-policy front. Not only has Fed Chairwoman Janet Yellen's testimony on Capitol Hill sent stocks higher today, but it has also taken much of the fear out of the market -- at least according to the S&P Volatility Index (VOLATILITYINDICES:^VIX), also known as the Fear Index, which has fallen almost 6% today to return close to its position before the market correction began. But should you be convinced, or is it smarter to remain fearful as others turn greedy?

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Image source: Victor Bezrukov, commons.wikimedia.org.

Investors have looked for ways to profit from a potential pullback, and volatility-linked investments have seemed like a natural choice. In general, volatility spikes higher as the market starts to drop, and that happened over the past couple of weeks. From Jan. 22 to Feb. 5, the iPath S&P 500 VIX Short-Term Futures ETN (NYSEMKT:VXX) soared almost 35% despite representing an unleveraged vehicle tracking volatility futures. The leveraged VelocityShares Daily 2x VIX ST ETN (NASDAQ:TVIX) posted a better than 72% gain over that time frame.

As happened repeatedly during 2013, however, spikes in volatility have proven short-lived. In less than a week, the two investments above have lost 19% and 35%, respectively, showing that betting on volatility is itself a volatile bet. That's the same kind of price action that sent both of those investments to big losses last year.

Investors seem to be getting the message. For the first time ever, the inverse-volatility VelocityShares Daily Inverse VIX ST ETN (NASDAQ:XIV) had more assets under management late last week than the iPath VIX ETN. In other words, investors are willing to put money behind their belief that the complacency in the market will continue. That's been a winning move lately, but it also relies on stability in a market that has been known to defy expectations at every turn in the past.

For now, investors are showing their belief that the Dow's pullback is over by bidding up volatility investments that do well in bull markets. Contrarians should take note, especially given the rapidity with which sentiment is shifting back and forth, and avoid assuming that everything will be rosy for the rest of 2014.

Don't let volatility knock you out of the market
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Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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