Fundamentally: The Worry Meter May Overlook Some Warning Signs

So can investors calm down?

Unfortunately, the answer is no. The problem with traditional volatility gauges is that they’ve never been great predictors of future market activity. For example, the Chicago Board Options Exchange Volatility Index, or VIX, which measures fear based on Standard Poor’s 500 options contracts that are used to hedge volatility, was near its historical average and showed no worrisome rise in jitters on Oct. 9, 2007, at the start of the last bear market.

In fact, it wasn’t until November of that year, when stocks had already lost 10 percent of their value, that the VIX started flashing a warning sign, climbing to a reading of 30 — about twice the average.

“We know that huge shocks in the market can trigger large movements in the VIX,” said Jason Hsu, chief investment officer at Research Affiliates, an investment consulting firm in Newport Beach, Calif. “But it’s not clear that nervousness in the stock market can be picked up in the VIX before big movements in the market are felt.”

The same goes for another gauge of market skittishness — one that tracks fear by tallying the number of trading days when stock prices swing — up or down — by 1 percent or more.

By this standard, market fear is virtually nonexistent today, as the S. P. 500-stock index is on track this year to post 25 days of such 1 percent moves, according to InvesTech Market Research. That’s down from 76 days last year, 117 in 2009, and 134 in 2008.

But investors shouldn’t necessarily assume that smooth sailing is ahead.

Sam Stovall, chief investment strategist for S. P. Equity Research, studied days when the market had lost at least 1 percent of its value, going back to 1956. He found that in the final three months of bull markets, the S. P. 500 has only 5.7 such down days, on average. Yet in the three months after a new bear market begins, that number nearly doubles, to 11.

“A pickup in volatility seems to be more of a coincident indicator than a leading one,” Mr. Stovall said. Or, as I’d put it, volatility isn’t a problem until it becomes a problem. Still, this doesn’t mean that classic gauges of market jitters are worthless in analyzing risk. In fact, volatility gauges can be useful to bulls and bears alike.

Market optimists, for example, can take comfort in knowing that volatility readings tend to jump at big transitional moments in the market when there’s a great debate as to the general direction of stocks and the economy.

That may be why the biggest rise in volatility tends to take place in the first year of a new bull or bear market, when it’s hard for market participants to tell that a shift has even taken place. In the first year of a new bull market, for example, the market averages 29 days when losses exceed 1 percent, according to S. P. But in second years, that figure falls to 16. And in the third year of a rally, it drops to 11.

Mr. Hsu argues that there are plenty of reasons for investors to be worried these days — among them, slowing corporate earnings growth and continuing, tough fiscal challenges among governments worldwide. But the lack of a meaningful rise in volatility would seem to indicate that investors for the most part agree that we’re in store for a slowdown, and not another recession and bear market.

“This is more of a sign of lowered expectations, not a double dip,” he said.

Nevertheless, bearish investors would do well to keep tabs on volatility, market strategists say.

That’s because volatility can be a contrarian indicator. Indeed, “some of the most dangerous periods for the market have come when volatility was at its lowest,” said James B. Stack, editor of the InvesTech Market Analyst newsletter. “That’s when you have the most widespread sense of complacency in the market.”

A perfect example of this was in 2007, when the financial crisis was just starting and the VIX hovered between 16 and 18, about where it is today.

TIMOTHY W. HAYES, chief investment strategist at Ned Davis Research, said that the “time to be concerned is when volatility readings really start to pick up at the same time you see the market breaking down.”

So far, investors have witnessed half of that combination, as stocks have lost around 7 percent of their value since late April.

If selling should continue as volatility starts to climb, investors may really need to worry.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=9ac42971cb2eed47ac0c64dea1bfaadc