Knowing When Others Are Fearful

The correction in this past month has been fairly amazing. Stocks had been falling faster than I could juggle and yet, the Straits Times Index actually ended the month basically unchanged. The Dow Jones Industrial Average (DJIA) even closed at a record high, as if no correction had happened. Whenever the stock market goes on a nosedive, I would be reminded to check an indicator, which is the Chicago Board Options Exchange Market Volatility Index, or VIX in short. VIX is used by some investors as a fear indicator, spiking up whenever there is great volatility in the market and staying low when the market is peaceful. As Warren Buffett said, “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”. It is useful to have an indicator to know when others are fearful.

Relationship between VIX and DJIA

The chart above shows the relationship between VIX and DJIA. As you can see from the chart, whenever VIX spikes up, a bottom tends to form around these spikes. However, note that this bottom might just be a temporary one, as the market might bounce back up before declining further. Also during the Global Financial Crisis (GFC), VIX actually hit a high of 81 in Nov 2008 but the market continued to crash through before finally bottoming out in Mar 2009. If you had entered the market at the first instance VIX hit 40 and above on 29 Sep 2008, where DJIA was at 10,365 points, you would be nursing a loss of 37% when the DJIA finally bottomed out at 6,547 points on 9 Mar 2009. So, is it still a useful indicator for timing your market entry?

Firstly, I don't rely solely on this indicator to determine my entry point. In times of great market stress, gut feel invariably plays a big part despite all the game plans and indicators. You need to be really comfortable and mentally prepared to catch and hold a falling knife that shows no sign of stopping. It is no use buying and then selling out a few days later at lower prices because of rapidly mounting losses. Secondly, VIX itself can be very volatile whenever there is great volatility in the market. One day, it could be 35 while the next day, it could spike up to 47, before falling back to 39 the following day. So, VIX on individual days might not be very reliable. But if VIX continues to stay consistently high for several weeks, then it shows there is a lot of fear in the market. The longer the panic selling continues, the closer we are to the bottom. Thirdly, even though VIX is not useful in predicting where the bottom is, I use it to gauge roughly when the bottom is. Using the GFC example above, while you would be nursing a heavy loss of 37% if you had entered the market at the first instance VIX hit 40 and above, you would miss the bottom by a little over 5 months, which to me, is actually not that bad. And if you had waited a little longer to see if VIX had stayed consistently high, you would be even closer to the bottom and entered the market at an even lower entry point. Nobody can predict where the bottom is with certainty. I would be sufficiently satisfied if it could gauge when the bottom is with a error margin of a few months.

In conclusion, VIX can be a useful indicator to know when others are fearful, but understand its limitations and ultimately, you must be really comfortable and fully prepared to accept losses which could mount rapidly if you choose to catch the falling knife. It is also important to note that it helps a lot if you have sufficient cash reserves to cushion the fall. And it is also not necessary to catch the falling knife all at one go. It is normal to get hurt from it, but make sure the wounds are not fatal.

See related blog posts:

• Be Cautious While Being Greedy
• Different Types of Bears
• The Big Picture During Bear Markets