Watching the stock market, we would do well to recall Bobby McFerrin’s song “Don’t Worry, Be Happy.” Apart from being a global hit in 1988, as well as an unofficial theme song for the senior George Bush’s presidential campaign, the song offers a useful message:
“In every life we have some trouble
When you worry you make it double …
Don’t worry, be happy.”
Financial industry computerization quantifies, at least as it relates to money, the vague advice of the song. Something dubbed “the fear index” is a relatively recent (just 25 years old) tool entered into the lexicon of the financial service products — one more asset created out of thin air on which investors can bet — or hedge their bets, as it were.
The index to which I refer is the CBOE Volatility Index, which the Chicago Board of Options Exchange uses to measure the degree of expected volatility in the market. Known as the “VIX,” it reflects the price of S&P 500 options with a 30-day term.
If investors believe the market will advance or decline substantially with high probability, they will pay more for the right to buy S&P 500 stocks at today’s price at a later date (a call option), or they will pay more to sell in the future at today’s price (a put option).
Hoping I haven’t lost everyone already, from here it gets complicated. Suffice it to say that a high value of the VIX reflects the collective belief that the market is headed for some wide swings — lots of volatility and hence the “fear index” moniker.
A normal VIX rate is 15, which reflects the expectation that the market will move up or down within an annualized expected rate of 15 percent over the life of the option. Compare this to the old pre-computerized days, when the typical alternative to today’s VIX was someone asking J.P. Morgan what he thought the market will do. He famously answered, “It will fluctuate.” Now, we have a number valued by the second.
Right now, the value of the VIX is at the lowest point in decades — at 9, which suggests investors have been lulled into a state of complacency. We’re unworried and happy, apparently.
In the face of this, there is Warren Buffett, who wisely counsels us to “be fearful when others are greedy and greedy when others are fearful.” A nation of investors who have sent market averages to all-time highs might be seen as “greedy” in some quarters for not taking at least some chips off the table.
Contributing to investor complacency is the fact that Wall Street responds better when nothing is happening in Washington. It may seem counterintuitive, but gridlock in the nation’s capital is the investor’s friend. If the day ever comes when the squabbling and tweets end, things may start happening, and then there will be the “what next?” problem. Uncertainty is what gets in the way of optimistic expectations, because we tend to dwell on the worst that may happen.
The stock market is reflecting a healthy economy and record corporate profits — plus the expectation that both will continue for some time. What it can’t anticipate is something called “event risk” — the risk that some event will come out of the woodwork and shock the economic system. This could be surprise news from Washington, or some unanticipated international crisis.
There is never a time to just bail out of stocks and bonds and move to cash, but there is something to be said for investing more conservatively in dividend-paying stocks (through mutual funds) and so-called balanced funds that typically hold about a third of their assets in bonds.
As we saw the last time around, the stock market values periodically become disconnected from their role of reflecting the values of the actual companies they represent. With a balanced portfolio, the interest on bonds and the dividends on stocks will keep rolling in regardless of any short-term dip of a disconnect.
Figuratively speaking, though, we want to avoid the picture McFerrin paints when he sings:
“The landlord say your rent is late
He may have to litigate …”
This Article Was Originally From *This Site*