The Vicious Cycle of Fear in the Markets

Fear is back. Two days of heavy selling along with a 10 percent loss in the S&P 500 Index (.SPX) caused a noticeable uptick in risk perceptions Wednesday and Thursday. The CBOE Volatility Index (.VIX) is up from 47.73 to 63.68, or 15.95 points since Tuesday, the second largest two-day rally ever. The biggest two-day point gain in the VIX was roughly two weeks ago when it jumped 16.68 points on October 21 and October 22 to close near 70. While the market's "fear gauge" hasn't returned to the levels seen on October 22 or its record highs above 80 on October 27, the risks of further losses for the equity markets remain high because, although bearishness is at extremes, it is still rising-setting the stage for another wave of selling as the cycle feeds on itself.

Prior to Wednesday's sell-off, some encouraging signs started to surface. The extreme bearishness that developed in mid-October was beginning to ease. Not only had VIX fallen to early October levels below 50, but put volume in the options market started to subside. For example, the CBOE put to call ratio jumped to extremes in mid-October as nervous investors scrambled to buy index puts to hedge portfolios. (The Chicago Board Options Exchange [CBOE] is the largest exchange for trading S&P 500 and other index put and call options.) By October 10, the 10-day day average of the ratio (below) had reached 1.26, suggesting that call volume was running 80 percent of the total put activity. That ratio has since fallen from those extremes and is now at 1.00. Investors are no longer leaning so heavily on the index market for portfolio protection.

Figure 1: CBOE Put-to-Call Ratio (10-day Average). Click for larger view.

The investor sentiment surveys showed improvement. According to Investors Intelligence, 30.3 percent of those surveyed are now bullish, compared to 23.1 percent the week before. Bearish sentiment fell from 52.7 to 48.3 percent. Meanwhile, the American Association of Individual Investors reports bullishness rose to 44.83 from 37.14 percent. Bearishness fell to 33.33 from 40.57 percent.

Everything's changed now. The two-day 10 percent slide in the S&P 500 put a lid on any potential bullishness or optimism that might have started to bubble to the surface. Risk perceptions are rising once again. From a contrary view of the markets, signs extreme bearishness and pessimism are often viewed as a positive because the "crowd" is generally wrong at important turning points. The problem in the current environment is the dramatic volatility and decline in stock prices is triggering fund redemptions. These problems are amplified by the fact that many hedge funds have been extremely leveraged. As they meet redemptions, they are forced to de-leverage to raise cash. But it's not only hedge funds, simple open end mutual funds have very low ratios of cash According to the Investment Company Institute, the average fund held only 4.7 percent of its assets in liquid assets at the end of September 2008.

Moreover, the wave of fund redemptions appears to be continuing despite the market rebound in late October/early November. According to AMG Data, equity funds (excluding ETFs) saw net outflows of $565 million in the week ended November 5. The flows follow $40.5 billion in redemptions during the month of October and $75.3 billion of outflows during the third quarter.

In the last Sentiment Review, I noted that the current market environment had turned from extreme panic and fear seen in early October to one of despondency and despair. Consequently, it was unlikely that the market could stage a dramatic V-shaped recovery as the market had already been "washed out" by panic, but the general sense of discouragement, disinterest and disengagement on the part of many investors made a quick rebound unlikely. "Instead, no one event is likely to end the bear market. It seems like it will probably take a series of events and might take a significant amount of time before investor confidence is restored."

This week's market slide is another one of those events. It also poses a significant risk in the short-term because, as levels of bearishness and pessimism rise, selling begets more selling and the cycle feeds on itself.

Stock position: None.

Comments

[peterthepai...:]

lower than that, walter...

2008 Nov 07 11:22 AM

[investor88:]

Agree the bearish market outlook out there. Dow 7k within reach after which there could be a strong bear rally again.

2008 Nov 07 07:40 PM