Thursday, November 20, 2008

FALL BELOW 776.76: Stable and Unstable VIX Patterns Impacting Changes in Allocation to Stocks, Bonds and Cash

During the last hour, the S & P 500 average fell below its daily low of 776.76 established during the last bear market on October 9, 2002.  It closed at 752.44 down 6.71% for the day. On that day in October 2002, the VIX  was near its high for the then ongoing bear market closing at 42.13. There is an inverse correlation between the VIX and the S & P 500 average.  In 2002,  a reading of 42  on the VIX  would have been a historical high indicating a heightened state of fear and anxiety, and any consistent reading over 30 would  indicate an ongoing bear market. If you knew nothing about the state of the stock market, and only could look at the VIX chart, you would know that there was an ongoing bear market in 2001-2002, just as you would today.

A steady reading in the 15 to 20 would mark a bull market while a steady 10 to 15 level would mark the second and likely final phase of a bull market. A spike out of the second phase in a bull market would indicate the start of a volatile, unstable VIX pattern which would signal, generally, a transition phase to a bear market with the VIX spiking over 30, then down below 20 and then back over 30 again.

This swing pattern will occur twice, possibly three times, before it is clear that there is a  bear market rather than just a correction. There were two swings in 2007 coming out of a stable second phase bull market pattern. The first major spike out of the stable range to 30 happened in August 2007, with the fall back to 17 in early October 2007 being, not a signal to buy, but a signal to sell into strength and to significantly reduce the allocation to stocks, which for me meant reducing stocks by 20% and moving those funds into cash. (the last warning was in early November 2007 with another spike to 30)  My models based on VIX and the other volatility indicators has kept me at that cash level ever since October 2007 and I am no where close to investing that money.   

The model does not predict the severity of the bear market. 

Nothing would have predicted a few months ago the severity of this bear market, which will easily surpass anything that I have seen in my lifetime. I did not live during the depression. I thought that 1974 was bad, but this one will be rivaled only by the great depression during the last 100 years. I would have to say that I am surprised by everything that has happened this year, from the failures of major investment banks including Lehman and Bear Stearns, the seizure of Fannie and Freddie and the failure or near failure of several large banking institutions. Now, after witnessing this carnage, it is not difficult to imagine more yet to come.  But the failures to come will be born more from the loss of confidence than the chicanery, arrogance & greed, and outright stupidity that precipitated the crisis. Now, is there anyone out there who is not questioning the soundness of their bank or the life insurance company that sold them an annuity? I found myself checking AM Best on the soundness of my life insurance company yesterday. I do not have a policy with Lincoln National or Hartford but looking at what has happened to their stocks this year would cause anyone to be concerned.  LNC HIG 

The VIX is now hovering at levels that it has never been at, not for a day or a week, but for several weeks, with the VIX being over 50 most of the time since early October. The VIX has spiked to more than 70 on several occasions since early October 2008, indicating a market under severe distress. It is my opinion that no sustainable rally can start at these elevated levels. Today, the VIX has hit 80 and is presently near 80. This is also true for the Nasdaq volatility index, VXN. The index for the Russell 2000 is just off the charts at over 85.  Best to just step back now and watch the train wreck unfold in all of its gory details. 

Citigroup is trading under $5 with over 700 million shares traded so far today. The action in this stock is reminiscent of many others this year, including Washington Mutual, Wachovia, & Lehman. I do not have an opinion on whether Citigroup is likely to fail but no one appears to have much confidence in it.  If it does run into trouble, who saves it?  Who is left to step into the fray as a white knight. J P Morgan, who stepped up to acquire Bear Stearns, is down almost 20% after announcing job cuts. MarketWatch  Bank of America, the savior for Merrill Lynch, is moving rapidly to a 25 year low, not to many points away from zero itself after falling to 11 and change today. If the money recently supplied to these big institutions does not go entirely for bonuses to those who are already paid too much, then what is left will go to finance the massive job cuts, hardly the intended purpose. Money is needed to free up credit which appears to be one of the last things the first 350 billion will be used for by these titans of finance. When I say the  real worth of the masters of the universe is negative,  what I am saying is that they are really worse than worthless but all of them will tell you with a straight face they are worth tens of millions a year, plus stock options, plus deferred compensation of tens of millions and so on and so forth.    

So I have bought about 10  books that I plan to read now. Possibly, if the VIX falls next year to 30, I may start the process of nibbling again due to boredom as much as anything else. Until that time, I will just observe the worldwide havoc caused by Wall Street, a complicit Congress catering to lobbyists or narrowly focused power bases, and an administration that may be classified in the decades to come by independent historians as one of the worst in the history of the United States. I am just glad to say a couple of things: one, I did not vote for Bush and two, when I risk money, it is my money so that I will be rewarded only for making correct decisions that increase my net worth and I will certainly feel the pain for the boneheaded ones.