Deciphering the VIX Index and the Rally in Overconfidence

Hip hip, hooray! Hip hip, hooray!

Our little big bull market celebrated its one-year anniversary yesterday, albeit in tentative style. The Dow managed to eke out an 11-point gain, while the broader S&P 500 fared only slightly better. Investors, it appears, are awaiting the next catalyst to keep the momentum going. But are they running out of excuses to buy?

It is difficult to know precisely what is going on inside the collective brain of the marketplace, but one indicator gives us a hint. The VIX Index, also known as Wall Street’s “Fear Gauge,” measures the implied volatility over the coming thirty days. A high reading represents costlier options, commonly used to hedge against any sudden down trend. A low reading indicates a lower hedging cost, meaning that traders expect relatively calm waters ahead. At its extremes, the VIX Index is a rather useful tool for contrarians. When the VIX breaches its moving averages to the upside, it’s usually a pretty good sign that the market is oversold. Conversely, when the index dips below certain key points, it’s probably a good time to expect the unexpected, so to speak.

Right now, the VIX is bobbing around close to its 18-month lows. That means traders are not forecasting much of anything…a pretty good sign that we’ll see quite a bit of something. Last Friday, the measure fell to 17.5, a level not seen since January…when the S&P promptly fell from around 1,150 to 1,050. Before that, the VIX had not seen a reading of 18 since August of 2008…right before the market went skydiving without a parachute. By March of 2009, a few short and painful months later, indexes around the world had almost managed to saw themselves in half…and worse.

Just before the global financial collapse, your editor took advantage of the rampant overconfidence in the market to implement a little preemptive “austerity plan” of his own. And so, from the gaudy bubble-central of Dubai we took the long road east, making sure to pass through notably inexpensive destinations like India, Nepal and Southeast Asia. Without a country full of union workers to protest the move, this was relatively easy to do (sorry Greece…and France…and Britain…and, well, Europe). Here in the Far East, we can enjoy the same or better lifestyle for a fraction of the price. Rent is less than half what it was in Dubai. Food costs next to nothing. And, as an added bonus, your editor’s girlfriend is not obliged to dress like a ninja when we take weekend trips to neighboring countries…not even when we visit Japan.

One would need a degree in modern economic theory not to see the problems lurking below the surface of this market rally. That or a job in a government office…in which case you’re paid not to notice. But the fortunately untrained eye can’t help but notice the worsening unemployment situation, a deteriorating real estate market – especially in the commercial sector – and a public balance sheet that looks even worse than the private one that led us all into this mess in the first place.

While on our little pilgrimage of austerity – back at the end of ’08 – early ’09 – we ran into dozens of ex-bankers and newly redundant financial services workers. We found them lazing on the beaches of Viet Nam and sipping $2 daiquiris at the bars around Bangkok. A few of them had plans for the future, but mostly they were there to somehow, vaguely, “ride it out.”

Our little big bull market may be a year old but, if we had to bet, we’d say it’s a rally in overconfidence only, as presently exhibited by the VIX index. On the bright side, the bar staff at the resorts in Phuket can look forward to another influx of lost souls armed with loose severance packages.

Joel Bowman
for The Daily Reckoning