Investors Still Fearless, Relatively Speaking

With every new market low, investors everywhere want to know if this low equals a bottom. In the past couple of weeks the S&P 500 has gone right through the 1280 "line of support" without (wait for it......) any sort of resistance! As we can see by the chart below, the S&P hasn't been this low since roughly the summer of 2006. We now sit at 1252.31 off of a high of 1576 in Oct 2007. That's roughly 20% chopped right off the top of the market.

The question is, how can you as an investor know when the trend may reverse? Many critics of "technical analysis" will pose the philosophical question of "What's the point of a Support if it doesn't always have to provide support?" "What is the point of resistance, if sometimes it gives no resistance?"

Just to play Devil's advocate, could we not criticize fundamental analysis in an analagous manner? What is the point of a valuation based on fundamentals, if the fundamentals are based on assumptions? What's the point of making assumptions when everyone's assumptions are different, thus making valuations different, thus making valuations anything but concrete?

I agree with both sets of critics. Nothing in investing is concrete! Why? Because, a valuation boils down to what someone else values it at. That's it. The moment somebody is willing to purchase a share at that price, that is the stock's valuation at that moment. Just like the world is in a constant flux, just like people's psyche's are in a constant flux, just like the news is in a constant flux, prices too, are in a constant flux--and by default valuations are in a constant flux.

Fundamentals are never reliable (has anyone heard of Analyst Upgrades? or Raising Estimates?). Technicals are never reliable. They are simply tools of the trade of trading. What has been reliable as of late to mark trend reversals in the market is the VIX. Otherwise known as the volatility index.

Straight from Investopedia:

The ticker symbol for the Chicago Board Options Exchange [CBOE] Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge."

Why does the VIX seem to work? I believe it is because it measures investor sentiment about the market. If we really view the market as what it is -- a bunch of crazy investors frantically trying to revalue everything they own constantly -- then the VIX makes so much more sense. We make the market because we ARE the market. It's like trying to bargain for a good deal. You want to know as much about the other side as possible. The best time to buy is when they irrationally drop the price for irrational reasons.

What do you do when you want to make a Business deal? You get em' drunk! (Just Kidding. This site does not advocate the excessive consumption of alcohol under any circumstances. The previous statement was meant only in good humor.) So what do you do went you want to buy stocks? You make sure the other side is irrational and fearful. AKA You let the VIX spike up.

Peering at the chart above we see that the last significant "spike" in the VIX took place on Mar 17, 2008. This just happens to coincide with the last market bottom seen in the S&P 500. What a spike in the VIX signals is capitulation in the markets. Let's learn more from Investopedia, shall we:

After capitulation selling, it is thought that there are great bargains to be had. The belief is that everyone who wants to get out of a stock, for any reason (including forced selling due to margin calls), has sold. The price should then, theoretically, reverse or bounce off the lows. In other words, some investors believe that true capitulation is the sign of a bottom.

Once all the investors who want to get out, have sold irrationally the only ones that should be left, are the rational investors. If you are rationally invested in equities for any reason, in essence that means you are bullish on equities (whether it be short term or long term). Although we had a small spike up in the VIX yesterday, I can't say if it is convincing enough to signal a reversal. And noting that the next line of support (I'm using a bit of technical analysis... sue me) in the S&P is at 1226 (only 3% away -- see the S&P Chart above) I feel like we could easily drop to that level.

So be cautious investors, its murky waters out there.

 

Comments

[fxtrader07:]

now that everybody and his uncle stares at the vix to confirm the bottom (giving a Buy-/short cover signal) you can rest assured it won't work that way. they don't ring a bell in the markets (or a vix for that matter) to call you aboard or to send you off . never have and never will.

2008 Jul 08 09:36 AM

[icandoitdon:]

fxtrader07 beat me to the punch and he's right on point...

too many people looking at the vix and trading off it. beware trading on such a popular indicator.

2008 Jul 08 11:04 PM