Wall Street's 'fear gauge' jumps

The CBOE Volatility Index jumps as traders scramble to protect against a market selloff.

By Anthony Mirhaydari Jan 25, 2011 4:25PM

It's been a quiet couple of months for stocks as the major averages grind higher. In fact, the S&P 500 hasn't closed below its 50-day moving average since September 1. That's 99 trading days and represents the longest consecutive rally since early 2007.


But as I mentioned in my last blog post, there was evidence of trouble brewing. The smallest, riskiest, and most sensitive stocks in the market recently started to badly lag their larger brethren. Big disparities in the performance of small cap stocks vs. the mega cap stocks are frequently seen at turning points.

 

Things are playing out according to plan as stocks move lower today. As a result, investors are scrambling to protect their positions against continued declines by snapping up equity put options. That's pushing up the CBOE Volatility Index ($VIX), commonly known as Wall Street's "fear gauge" to levels not seen since November. The VIX has now moved over its 50-day moving average, a level that tends to coincide with significant market pullbacks.

 

 

You can see this in the chart above. The last time the VIX jumped its 50-day MA was back in November during the turmoil associated with the Irish bailout. Before that, the VIX made a move during the August selloff. Unless the VIX turns tail and moves lower soon, expect stock prices to continue to suffer.

 

But that's not all.

 

 

Other signs of trouble include the recent increase in measures of short-term market volatility vs. medium-term volatility expectations. These measures are derived from trading on S&P 500 options. When Wall Street worries about a correction, they buy put options for protection which drives up the cost or premium of the contracts. This gets reflected in the CBOE Volatility Index and CBOE 3-Month Volatility Index ($VXV) depending on how far into the future the turmoil is expected to be.

 

Right now, short-term volatility expectations are increasing relative to 3-month expectations. As a result, the ratio of the two has pushed up and over its 200-day moving average as shown in the chart above. This typically happens at market turning points or during periods of stress. The last example of this was back in November. Before that, it was back in the April/May period.

 

All of this suggests are set for a period of weakness after an incredible five-month rally.

 

Disclosure: Anthony does not own or control a position in any of the companies or funds mentioned.

 

Be sure to check out Anthony's new investment advisory service, The Edge. A two-week free trial has been extended to MSN Money readers.


The author can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

1Comment
Jan 25, 2011 5:50PM
avatar

Maybe-Just maybe stocks and their averages have ground a little too high for  a short period. The Fed is determined to keep the cheap money policy afloat. Stocks may be due for a short set back but will soon be off and running higher again.

 

My thoughts are:  Try to stick with large cap dividend payers.,  Hold them till we get an good interest rate increase, then rethink your positions.  After a  couple of interest rate hikes, that should drop  stock prices and dividend payers stock prices...

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