Surely this must be another sign of investor confidence, confirming that it's time to get back into stocks. Wall Street was watching the VIX closely on Tuesday. When it closed below 30 for the first time since the bankruptcy of Lehman Brothers, the event was immediately hailed as a bullish indicator.

The VIX index, commonly referred to as the “fear gauge” on Wall Street, reflects the market's expectation for future stock volatility. The index is derived from the prices of options on the S&P 500. Because future volatility is the only unknown input in the Black-Scholes formula for pricing options, it's possible to work back from the market prices for options to find option buyers' estimate of volatility.

Where we've been, where we are
From late 2007 through mid-2008, the VIX was in a range between 20 and 30, but it exploded after the Lehman bankruptcy, reaching an all-time high of 89.53 in October. Option buyers were furiously bidding up puts, desperate to obtain protection against stock price declines.

However, the VIX has declined steadily since March, despite the fact that stocks have been volatile (see table below), with the S&P 500 gaining more than 30% since its March 9 closing low. Not all volatility is created equal: It lulls investors on the upside, but downside volatility triggers a fight-or-flight response.


% Return From March 9 Stock Market Low*

Office Depot (NYSE:ODP)


Genworth Financial (NYSE:GNW)


Fifth Third Bancorp (NASDAQ:FITB)


American International Group (NYSE:AIG)


Huntington Bancshares (NASDAQ:HBAN)


Hartford Financial (NYSE:HIG)




*Returns at May 20, 2009.
Source: Standard & Poor’s Capital IQ.

Banks get comfortable
This "feel-good" milestone for the VIX comes on the back of several other signs that the capital markets are returning to normalcy. Last week, the TED spread, the difference between what banks and the U.S. Treasury pay to borrow over three months, fell to its lowest level since Aug. 8, 2007 (the next day, French bank BNP Paribas halted redemptions for three of its funds, citing losses on subprime mortgages -- one of the catalysts for the credit crisis).

Similarly, three-month U.S. dollar LIBOR, the rate at which banks lend to each other, fell to 0.7525% -- its lowest level since 1986, the year the British Bankers Association began publishing dollar LIBOR rates.

Both of these lows indicate that banks are becoming much more comfortable lending to each other. That's a critical condition for credit to flow normally from the financial system to the rest of the economy. As we've become all too aware of during this crisis, credit is a key cog in facilitating economic growth.

Is now a good time?
Does this mean that investors can now feel confident in getting back into the market? To answer that question, let's take a look at a valuation measure rather than the VIX, which is a technical indicator of investor sentiment.

Based on yesterday's closing price of 903.47, the S&P 500 is trading at 15.6 times average real earnings for the last 10 years (sometimes labeled the cyclically-adjusted P/E ratio, or CAPE). That is certainly less mouth-watering than the 11.7 times the index reached on March 9; however, data from Yale University's Robert Shiller shows that it is about in line with the 16.3 average multiple for stocks going back to 1881.

The prospect of reasonable returns
These numbers suggest that stocks are no longer superbly cheap, but they do offer the prospect of reasonable returns (say, 6% to 7.5% annualized after inflation) for long-term investors. Asset management firm GMO, which follows a fundamental orientation, estimated that large-capitalization U.S. stocks would return 7.5% annualized real returns, compared to the long-term historical average of 6.5%. Mind you, those estimates were as of the end of March, with the S&P 500 one hundred-odd points lower than it today and the CAPE at 13.8.

(By the way, the chairman of GMO, Jeremy Grantham, is a fan of the cyclically-adjusted P/E ratio.)

Walk, don't run
If your time horizon is adequate, those expectations dictate a significant exposure to stocks. Still, that isn't a prescription for rushed or indiscriminate action (if you have no exposure to stocks, I definitely think it's presently worth revisiting your rationale). Investors can add to their equity holdings incrementally as valuations become more attractive, and I think there are good odds that we'll witness stock price declines to get us back to or near the low achieved in March (or possibly even below -- the cyclically-adjusted P/E has bottomed out below 10 during prior crises).

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Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. The Fool owns shares of SPDRs. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.