Wednesday, December 03, 2008

Is the VIX a Good Predictor of the Stock Market?

The Volatility Index, or VIX, is an often quoted figure used in today’s markets. It is a calculation used to measure investor fear. Historically, it has held at around 20. Below 20 corresponds to less stressful times in the markets, and above 30 signifies high volatility due to investor fear or uncertainty.

Judging by recent movements in market indices (mention of a 300 point swing fails to interrupt my coffee break anymore), you might guess that the VIX is above 30. On 11/20, it topped out at an all time high of 81! Over the past few months, we have seen sustained VIX figures at unprecedented levels.

There have been numerous studies showing a strong correlation between the VIX and market performance. Since it is a forward indicator, VIX readings should help us to gauge market movements in the future. On Friday, the VIX closed at 55.28. From 11/20 until then, the DOW was up 14%. Investor fear went down, and markets went up. Pretty simple, right?

Common sense should tell us that the best entry point into the market is when the herd is getting out. An often-quoted Buffet proverb comes to mind—be greedy when others are fearful and fearful when others are greedy.

Putting considerable investment decision weight on the VIX is probably foolish, but positive contrarian indicators like this one help to re-affirm my belief that there is a light at the end of the tunnel. Eventually I have to be right, don’t I?

Aaron Konen

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