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 |
(16.9%) |
$69.9 billion |
|
General Electric |
(25.6%) |
$65.3 billion |
|
Bank of America |
(35.3%) |
$55.0 billion |
|
Microsoft |
(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
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
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:
