When Will the Wild Price Swings End?

I'll grant you, the current crisis is unusual in its breadth and intensity, forcing us to look back to the Crash of 1929 for reference points. Seven consecutive days of market decline? Never been seen until this month. The worst weekly performance in stock market history? It's all right here, folks.

A lesser-known indicator – the VIX index -- broke through its all-time highs several times in October. Known as the "fear index," the VIX offers investors valuable insight into the psychology of the market. Better yet, it looks like a buying signal right now.

V for volatility
The VIX index is an estimate of stock market volatility. More precisely, the figures for the VIX are reverse-engineered from option prices on the S&P 500 stock index, tracking option traders' estimate of the future volatility of the index. In other words, the VIX is the result of a poll of the market on how much it thinks stocks will move.

In distressed markets, option buyers are willing to pay up for protection, pushing the VIX index up. Last Thursday, with fear overwhelming the market, it spiked up to an all-time high of 81.17. Prior to this September, the all-time high – a mere 45.74 -- occurred 10 years ago, in the wake of Russia's debt default and the collapse of Long-Term Capital Management.

The Dow's $730 billion bloodletting
Much of the fear is stoked by the huge price volatility observed since the beginning of the month, in which a tsunami of relentless selling took a terrible toll on market values. The Dow Jones Industrial Average lost almost three-quarters of a trillion dollars in market capitalization, nearly a third of which was accounted for by the four stocks in this table:

Stock

October Month-to-Date Return

Market Value Destroyed in October

ExxonMobil (NYSE: XOM  )

(16.9%)

$69.9 billion

General Electric (NYSE: GE  )

(25.6%)

$65.3 billion

Bank of America (NYSE: BAC  )

(35.3%)

$55.0 billion

Microsoft (Nasdaq: MSFT  )

(19.3%)

$48.1 billion

One of the reasons we've been stunned by the market's recent volatility is that we exited brutally from a fairly lengthy period of lower-than-average volatility. Indeed, stock and bond markets worldwide exhibited low volatility from mid-2004 through the first quarter of 2006.

As such, we should have been expecting a bounce in volatility. And when volatility explodes – as it did this month -- we can expect that it will taper off at some point. Why? The fancy explanation is that volatility is mean-reverting; its average value exerts a gravitational pull on it, dragging it back toward the middle when it spikes too high or dips too low.

Despite these factors – large observed price swings in equity prices on the back of a long period of low volatility – it's not clear that the VIX is a foolproof indicator of future volatility right now. In the current market maelstrom, it's probable that option buyers, like stock investors, aren't acting purely on fundamentals. Here's an example from the stock world.

Has American Express lost 30% of its earnings power?
If you believe efficient-market theorists, stock prices incorporate all relevant information at all times, which makes trying to hunt for mispriced stocks a waste of time. Following that logic, the intrinsic value of American Express (NYSE: AXP  ) fell by almost 30% this month. Let's assume that American Express should be valued as a going concern (I've heard no one question this yet) and see where that takes us.

Such a decline implies that, all other things being equal, the market now estimates that all of American Express's future cash flows will be 30% lower than had been estimated less than a month ago -- for the remainder of the year, next year, and every year after that. Did the quality of the company's franchise really deteriorate that quickly? Really? I'll let you draw your own conclusions, but my mind is made up.

Volatility is the friend of the deliberate investor
Don't get me wrong, I have a lot of respect for the power of the market to produce prices that approximate fair value. Most of the time, most stocks are well-priced. Most of the time. However, during periods of upheaval such as this one, forced selling and investor panic produces massive volatility and short-circuits the market's brain. Under extreme stress, Mr. Market will make you all sorts of rare and very profitable propositions.

American Express is no isolated case. Two of the finest companies in the U.S., Home Depot (NYSE: HD  ) and Hewlett-Packard (NYSE: HPQ  ) lost nearly a quarter of their value in October.

Where does that leave you? Instead of asking when the volatility will end, you should be asking how you can take maximum advantage of the fantastic bargains it has created.

Further credit crisis Foolishness:

What now? The Motley Fool is here to answer your questions about this financial crisis. Send us an email at AsktheFool@fool.com, and check back at Fool.com as we answer your questions and cover the latest on the Panic of 2008.

Fool contributor Alex Dumortier, CFA wishes he had more cash to put to work right now. He has a beneficial interest in Microsoft and Home Depot, but not in any of the other companies mentioned in this article. Bank of America is a Motley Fool Income Investor pick. Microsoft, The Home Depot, and American Express Company are Motley Fool Inside Value picks. The Fool owns shares of American Express, as our disclosure policy obliges us to mention.


Read/Post Comments (3) | Recommend This Article (10)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 24, 2008, at 8:50 AM, SteveTheInvestor wrote:

    Stocks on sale?? Yeah, right. Been hearing that for the last year. The only problem is that they just keep going down with no end in sight. I'm not going to buy anything at 50% off when I know it will likely be 75% off sometime soon. Oh wait, let's wait for 80%. Yeah..... that's it.

  • Report this Comment On October 24, 2008, at 1:28 PM, TMFAleph1 wrote:

    Steve,

    Thanks for your comment. If you KNOW stocks are going to drop another 50%-60% from current levels, shouldn't you be shorting them right now? You'll be able to make tidy profits on top of the profits you'll make buying them once they reach their lows.

    Alex Dumortier (XMFMarathonMan)

  • Report this Comment On February 17, 2009, at 5:44 PM, nonameyouwont wrote:

    So whout macks you think stock will go down 75 to 80% befor it gos back up. JIM

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