VIX Index Spike: Fear Reemerges on Sovereign Debt Downgrade

Until very recently – as in, yesterday recently – there appeared to be little worth fearing in the stock markets. At least that’s what Wall Street’s “Fear Gauge” seemed to suggest. Cautious investors, of course, knew better than to trust their respective governments’ ability to do anything other than deepen and lengthen a crisis.

Prior to yesterday’s 2.3% tumble in the S&P 500, the VIX Index – which measures fear by calculating the price of option “insurance” against future market declines – had meandered into what, historically, has been rather dangerous territory.

“Right now, the VIX is bobbing around close to its 18-month lows,” your editor noticed aloud in these pages back in mid-March. “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,” we continued, “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…or worse.”

Determined to battle gravity with complacency, investors continued to shrug off the growing concerns of – among other things – sovereign debt crises during the ensuing month, pushing the S&P 500 higher and the VIX Index ever lower. What goes up, alas…

Lo and behold, the financial tragedy in Greece did not simply blow away in the wind. That ongoing fiasco and the associated threat of sovereign default contagion conspired yesterday with the Goldman goings-on to reveal an Achilles’ heel in the permabulls’ armor.

Standard & Poor’s, the venerable ratings agency perhaps best viewed as a lagging indicator of creditworthiness, yesterday saw fit to downgrade both Greece and Portugal’s sovereign debt rating. At BBB+, Spartan debt is now officially “junk” status, according to S&P; the first time a euro member has earned the dubious title since the currency experiment began. Portugal’s rating was also taken down a couple of notches, from A+ to A-.

The VIX, predictably, shot up 31% during the session to close the day out at 22.81 – its highest level since February 11 and the largest single-day spike since October 2008.

“It’s a very big concern,” Jon Corpina, senior managing partner at Meridian Equity Partners Inc., told Bloomberg. “It starts off with Greece and everyone looks at the map to see where else it can spread.”

A tougher question, perhaps, might be where can’t it spread. Europe’s PIIGS – Portugal, Ireland, Italy, Greece and Spain – are lining up for space at the trough, their muddied snouts in search of handouts and lifelines. How about the UK? Japan? The US? Fuggedaboutit. In addition to terrible finances of their own, the world’s most ‘advanced’ economies are also facing intractable demographic problems, whereby more and more welfare recipients will come to depend on fewer taxpaying contributors in coming years.

As it turns out, things can go wrong in happy-smiley markets. Indeed, sometimes they even do go wrong…dreadfully so. We’re not quite at the “dreadful” stage yet, not officially…but give it time.

Joel Bowman
for The Daily Reckoning

The Daily Reckoning