Fear And Greed As Stock Market Indicators

The Chicago Board Options Exchange's Volatility Index (VIX) measures the implied volatility of put and call options based on the Standard & Poor's 500. The CBOE markets the VIX as an "investor fear gauge," in that a high VIX reading indicates that investors are worried. Contrarian investors believe that the market is likely to move in a direction contrary to the consensus opinion; therefore, the VIX is a favorite indicator for many contrarians.

OPTIONS PRICING
Methods for valuing options — including the best-known and most widely respected method, the Black-Scholes model created in 1973 by Fisher Black and Myron Scholes — are generally based on the price at which the option can be utilized (the strike price), the amount of time until the option expires, and volatility. The first two factors are fixed. Hence, any change in an option's price suggests a change in perception about the stock's volatility.

Historical volatility quantifies that a stock's price changes over time; implied volatility is the volatility implied by a particular option price and will vary from historical volatility when investor sentiment has changed. For instance, a stock that has a history of wide price changes — that is, has a high historical volatility — is generally more attractive to an options trader than a stock that moves in a narrow range or, worse, flat-lines.

APPLYING VIX
Implied volatility increases when investors turn bearish because options can be used as a defensive strategy to ward off losses during a bear market. Under this scenario, a favorite tactic is to use put options, which allow the holder to sell the underlying security at a set price to create a floor on potential losses. The put option serves as insurance against a precipitous price drop.

While there are many interpretations of the VIX, a level below 20 is generally considered to be bearish, indicating that investors have become overly complacent. When the VIX is greater than 30, a high level of investor fear is implied, which is bullish from a contrarian viewpoint.

Another approach to the VIX is to focus on the speed of changes. A spike upward is considered bullish because it indicates a newly heightened perception of risk, while a sharp decline is bearish, suggesting complacent overconfidence.

Volatility should not be confused with beta, which measures a stock's price changes in relation to the overall market. Beta is the ratio of a particular stock's volatility to the volatility of the overall market, and is sometimes referred to as "relative volatility." A stock with a beta of 1 has a history of prices that moves in lockstep with the overall market. If the beta is less than 1, the stock historically moves at a slower pace, while a beta greater than 1 reflects a history of greater changes.

As beta works in both bull and bear markets, a low-beta stock is likely to outperform in a down market but will tend to underperform during a bull market. The opposite is true of high-beta stocks. Beta is a centerpiece of the capital asset pricing model, which holds that a stock portfolio should have a range of betas to eliminate the "systematic risk" that all of the stocks in the portfolio will tank together.

MEASURING INVESTOR GREED
Since the VIX is designed as a measure of investor fear, a natural followup is to look for a measure of investor greed — that is, the desire for profits. For this category, I would nominate the affluent investor index (AII) and the millionaires' index (MI), developed by the Spectrum Group.

The AII is based on monthly telephone surveys of approximately 250 individuals with at least $500,000 of household assets to invest, approximately half of whom have a household net worth (including real estate) of at least $1 million and are included in the MI. The Spectrum Group estimates that affluent households (those with at least $500,000 to invest) own nearly 90% of all stocks, bonds, and other financial assets. The surveys include questions about how secure the respondents feel about their incomes, jobs, and investments, as well as their plans in the coming months to invest in the stock market, mutual funds, and other investments.

The indexes reached lows in August and September 2004 and rebounded sharply in December 2004, after the uncertainty caused by the US Presidential election was removed. Likewise, the Dow Jones Industrial Average (DJIA) fell during most of the autumn of that year but rebounded in December, more than making up for the previous losses. In April 2005, the indexes fell sharply, which was reflected in the stock market's performance at that time. The indexes improved in May, as did the stock market, but lost steam as the summer progressed. In late autumn, the indexes sharply improved, which presaged the end-of-year rally.

The usefulness of the MI and AII is hard to tally, particularly since the investment outlooks of affluent individuals are likely heavily influenced by the performance of their portfolios. Therefore, in the long run, the MI and AII could be lagging indicators, rather than predictors of changes in trends.

Among the more general information revealed by the MI and AII surveys is that millionaires consistently are more optimistic than those who are only in the affluent group, and that although women are generally more cautious than men when making financial decisions, their long-term investments are the same as those of men.

More specific to the stock market, the most recent Spectrum surveys have shown increasing concerns about real estate prices and an increased willingness to move money from "the sidelines" (cash and cash equivalents) into the stock market.

James Maccaro is an attorney and freelance writer. He has written articles for Newsday, Ideas on Liberty, The Massachusetts Law Review, and other magazines. He can be reached at jam@juno.com.

SUGGESTED READING
McBreen, Catherine S. [2005]. "Financial Attitudes of Affluent Households Affect Consumer Spending," Research Review, Volume 12, No. 2.
Peterson, Dennis D. [2001]. "Market Breadth Or Beta?" Technical Analysis of Stocks & Commodities, Volume 19: Bonus Issue.

· www.spectrum.com

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