Sent: 23-08-2011 13:59:02
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If Not the End of the World, an Opportunity!
There will be an end of the world but, if this isn't it, extreme market volatility has a silver lining. History says you should now be invested.
The huge intraday swings in equity markets that grabbed the headlines last week pushed the Chicago Board Options Exchange volatility index, commonly referred to as the VIX, to levels that had only been reached six times in the past 15 years.
The so-called fear gauge measures the volatility implied by equity index options traded on the Chicago exchange.
The chart at http://www.thebigpicture.com.au/atc/vix.pdf shows the daily closing VIX values since 1995. There have been six prior events during which the VIX closed at or above the level at which it closed on Friday.
- The Asian financial crisis in 1997
- The Russian financial crisis, collapse of LTCM and ensuing Fed bailout of creditors in 1998.
- The bursting of the .com bubble and subsequent business closures in 2001.
- The collapse of Enron and WorldCom in 2002 and the accompanying audit and accounting scandals.
- The failure of north Atlantic banks and the collapse of investment banking lines of credit in the USA in 2008.
- The European sovereign debt crisis in 2010.
As the fear associated with these events and measured by the VIX subsided, markets regained some composure and posted large gains in the months immediately after displaying their greatest anxiety.
The table below shows gains made by the S&P500 index during the four months after the peak value in the VIX had been hit. With the exception of the period associated with the European debt crisis, the market made a double digit gain in each instance within the following four months.
|Asian financial crisis||+13.4%|
|Russian financial crisis||+29.5%|
|.com bubble bursting||+13.5%|
|Failure of Enron and WorldCom||+19.6%|
|North Atlantic banking failure||+15.9%|
|European sovereign debt crisis||+6.6%|
The 6.6% gain within four months of the VIX hitting its peak response to the European debt crisis was relatively modest. However, within seven months of the VIX hitting its peak, the market had risen by 16% and by 25% after 12 months.
Apparently, when the fear of further market losses is at its greatest, the potential returns from investing are at their greatest, too.
Conversely, quitting when the fear is greatest probably removes the best chance of recouping losses that had been made while the market had been weakening.
Of course, there is a risk in looking at markets in this way. As we saw in 2008, market anxiety reached unparalleled levels before relative calm was restored. In that case, extrapolating the rise in the VIX past the previous peaks before buying into the market once again would have made sense.
In short, these are investment markets so there are no foolproof paths to riches. Nonetheless, history says that we should not be afraid of fear. Significant market volatility offers opportunities that are not otherwise available. Now for the test: will it happen again?
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