Why have investors been so cheery of late? One reason may be the relative calm on Wall Street.
The numbers indeed show that the market has been fairly sedate lately. The most closely followed gauge of market fear is the Chicago Board Options Exchange Volatility Index, and it’s been sinking.
Engrossed: Traders at the New York Stock Exchange on Friday. Brendan McDermid / Reuters
Last week, the VIX, as the index is commonly called, fell below 30 for the first time since September, about the time that the collapse of Lehman Brothers Holdings Inc. set off a wave of panic.
The VIX reached 50 earlier this year and hit 80 last autumn.
Some market bulls say this ebb in the volatility numbers confirms that the rally that began in early March is real, because it shows that much of the anxiety that scared investors away from stocks appears to be dissipating.
But don’t assume that volatility is gone for good.
History shows that rallies that emerge from the depths of bear markets are almost always followed by a “retesting” of those market lows. “We always tend to get a very sharp rally off a bear market low,” said Sam Stovall, chief investment strategist for Standard and Poor’s. “And like it or not, we tend to get a decline thereafter, as the market digests what it just gained.”
Sometimes, the retests can be mild. For example, after the recovery rally that took place at the end of the 1982 bear market, the S&P 500 stock index fell about 4%.
But retests can also be frightening. After stocks rallied in October 2002, the S&P 500 suffered another scare that pushed stock prices lower by 15%.
Stovall studied retests going back to 1957, and found that the average such event lowered stock prices about 7%. But those that followed “mega downturns”—like the one the market suffered over the last year or two—took down the S&P 500 by 14%, on average.
So let’s assume that the rally that began in early March peaked on 8 May, with the S&P 500 at 929 points. A correction of 14% would bring down the index to 799. Based on its current level, the market would have to fall an additional 13% or so to reach that level.
“If we’re going to go through a retest that could be as severe as a correction—a 10-20% decline—I would tend to think that panic will return,” Stovall said.
Jeffrey N. Kleintop, chief market strategist at LPL Financial in Boston, agrees that volatility will stage a comeback. He said he expected another wave of selling to erase about half of the 36% gain that stocks have achieved since their March lows. That means that even though volatility tends to decline during the summer months, he said, “the next few months will see higher volatility than the past two-three months of relatively steady gains”.
To be sure, that volatility may not be as severe as it was when stocks were setting their bear market lows.
For instance, when the 2000-02 bear market ended on 9 October 2002, the VIX climbed as high as 42 before falling back into the low 20s. During the subsequent retest, the VIX climbed again, but never made it all the way back above 40.
Still, there are plenty of reasons to believe that volatility will re-emerge soon.
For starters, Kleintop said, there’s the relative uncertainty still surrounding the economy. Both bulls and bears may overreact to economic reports in the coming weeks, giving stocks a bumpy few months, he said.
So, if the global markets stumble, there’s a good chance that investors’ current courage will turn into another bout of fear, which will spill over into a drop in domestic stocks.
Is the bear market really over? Watch the VIX.
©2009 / THE NEW YORK TIMES