What does the FEAR index tell us about market conditions and the turmoil in China?

by | Feb 15, 2016 | All Articles, Technical Analysis

Perhaps you’ve heard of the FEAR index? It’s not an actual index. It’s what the VIX (S&P500 Volatility Index) is also known as. And with good reason.

The VIX measures implied volatility—what is expected in the future. The reason it’s called the FEAR index is because the higher it is, the more it costs to insure the portfolio. When market participants expect or ‘foresee’ higher near-term volatility, that translates into a higher cost of protection because it costs more to insure.

Here’s a chart of the S&P500 with the VIX below:

(Above: the SPY–S&P500 Index in the top pane with its VIX–Volatility Index in the lower pane)

FEAR and Flood Insurance?

Let’s think about a non-market example from the past – Hurricane Katrina. Let’s say flood insurance in Louisiana was $100/month before Katrina and $1000/month afterwards. This is exactly what happens to volatility in the markets after prices cascade down for a period. And just like the rise in flood insurance, it’s likely too late to insure when it’s obvious you need it – and now no one wants to insure you. Why? The price is so high. Ironic.

FEAR: What does it tell us?

News about market volatility is ever-present in the media. Unfortunately for many, this doesn’t mean much. Is there a way to find something meaningful from volatility? One way to do this is by looking at the implied volatility indexes for all stocks in the S&P500 to get a sense of how widespread panic may or may not be.

Using a market statistic on a wide range of securities for analysis is called breadth.

Here is a breadth chart of the S&P500 going back ten years. Below is the percent of stocks above certain ranges of past implied volatility. Purple is higher than 80% of the past year, blue 90% and orange is +100% (the highest it’s been).

(Above: SPY–S&P500 Index with Percent Stocks above 80%, 90% and 100% of their respective annual Volatility Indexes)

The first thing I notice is when a large percentage of the stocks are at the upper range of annual implied volatility, prices might be near a low. It’s at these extreme ranges I often hear portfolio managers jokingly say, “We are all well-hedged for what has just happened.” They are effectively buying insurance when it is most expensive and probably at a time when it’s too late to help. Additionally, notice the lack of 10% spikes in 2015. We’ve had some substantial pullbacks with little spiking in volatility from the S&P500 stocks.

(Above: Arrows show when 10% of the S&P500 stocks were 80%, 90% or 100% of their past year’s Implied Volatility measures during an uptrend.)

Let’s take a look at what happens when 10% of stocks cross their 80, 90 and 100 marks. The above chart shows with arrows when 10% of stocks reach extreme levels of what it costs to insure them. They were mostly near a market bottom. Well, this is an uptrend, how about a downtrend?

(Above: Arrows show when 10% of the S&P500 stocks were 80%, 90% or 100% of their past year’s Implied Volatility measures during an downtrend.)

In the downtrends, these still look like bottoms, but the trend re-exerts itself. Also, the more extreme the measure the more likely we are near a turning point. Some call that capitulation (when the market “gives up” on a trend, and it turns, or reverses direction and momentum). These are more places where reflex rallies might occur versus a trend change from down to up.

FEAR: What are we afraid of?

My takeaways? The current market is noticeably missing a spike in the percentage of stocks hitting extreme implied volatility measures.

This is incredible considering all the news on how bad China’s slowing economy will be for the world, and the two recent 12-13% declines in the S&P500 in May 2015 and Nov 2015 (shown in the chart below). Even more incredible is that it doesn’t even remotely resemble 2007-2008 where there were multiple extreme measures in volatility.

(Above, the last two declines in the S&P500 have not taken 10% of stocks to extreme volatility measures.)

This leads me to believe:

a) the worst is yet to come, or

b) the markets are not as bad as the media is painting them.

Either way, I can use breadth to keep my finger on the pulse of FEAR. 

If FEAR does escalate, if volatility reaches an extreme measure, I will look for a bottom to start forming and constructive market action to follow.

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Carson Dahlberg, CMT

Carson Dahlberg, CMT

Author & Co-founder of Northington Dahlberg Research

Carson comes to Optuma bringing nearly 20 years of experience in the financial markets involved in technical and quantitative trading, research and education. Carson has worked for several notable firms: Morgan Stanley, Wachovia Securities, Wells Fargo, and Schaeffer’s Investment Research. In addition, he is the co-founder of Northington Dahlberg Research, a quantitative driven, volatility-based research firm, and was the Director of the CMTinstitute (an online program to assist financial professionals in the passing of the CMT examination process).

Carson is presently a Director at Large on the Board of the Market Technicians Association and serves the Market Technicians Association (MTA) in various capacities. He was the founder and first Chapter Chair of the Charlotte Chapter for the MTA. His involvement with being the Committee Chair for the Ethics Committee has led to an updated and globally relevant ethics offering for the designation. In the past, he has served on the Admissions Committee, was the Board Liaison for the Journal of Technical Analysis Committee, and was the Director of the CMTinstitute.

Carson received a degree in Chemistry from the University of Cincinnati and was awarded the Chartered Market Technician designation in January of 2008.

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