The Aftermath of Standard & Poor's Rating

In the wake of “Great S&P Downgrade” volatility in the stock market as measured by the VIX — the volume of S&P 500 index options — jumped 50% yesterday.

The market’s “fear gauge” closed out the day at 48.

You may recall we noticed “fear is cheap” several occasions in the last year as the VIX hovered around 20.

Political stunt or no, the S&P downgrade of U.S. Treasuries shocked traders and investors more than Mssrs. Forbes, Summers, Buffett, Geithner or Greenspan would like to admit.

Going back to its inception in 1993, there are only five other episodes in which the VIX topped 45:

• September 1998: Russian default
• October 1998: Long-Term Capital Management (LTCM) implosion
• August 2002: WorldCom collapse
• September 2008: Lehman Bros. bankruptcy and ensuing Panic of ’08
• May 2010: The incestuous “flash crash.”

In four of five of these spooky episodes, you could have done very nicely for yourself buying the Dow 30 as soon as the VIX topped 45… and holding those shares for a year. The blue chips picked up between 1,500-2,500 points each time.

The 2008 episode, however, proved to be a horrendous “head fake” for traders trying to cash in on the trend.

On Sept. 29, 2008, when the Dow experienced its worst point drop ever, the VIX topped 45. The VIX then settled back down for a few days only to shoot up to 80 by Nov. 20. The Dow spiraled downward for the ensuing winter… until early March 2009.

A full 12 months after that 2008 “head fake,” the Dow was still off its peak by more than 600 points.

So today, after yesterday’s VIX spike, you have to ask yourself, in the immortal words of Clint Eastwood, “Do I feel lucky?”

Before you answer, consider there’s a Fed meeting today.

The announcement will be out by the time you read this, and we’ll have some kind of signal about the prospects for “QE3” — yet another round of easy money — and an attempt to goose the flagging market anew.

You might expect Fed chief Ben Bernanke to laud QE2 because of its effect on stock prices: Easy money fuels the “wealth effect”… people feel flush as their brokerage accounts grow… and then go out and spend money.

Of course, it’s a dopey notion — based on the idea that consumption grows the economy, not savings and production. But it is what it is.

At yesterday’s close, the S&P 500 is only 70 points away from where the whole QE2 process started nearly a year ago — when Bernanke winked and said it was all but a done deal during his annual speech in Jackson Hole, Wyo.

When Bernanke indicated during his first news conference on April 27, 2011 that QE2 would wind down as scheduled at the end of June, the market topped two days later. The market then entered a holding pattern until the circus over the debt ceiling concluded… then, well, the last week of July through this morning tells the rest of the story.


Addison Wiggin,
for The Daily Reckoning