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VIX and Risk Indicators Could Signal Market's Next Move

VIX and Risk Indicators Could Signal Marketís Next Move
By Ron DeLegge
October 28, 2009

SAN DIEGO ( Ė Is the worst over? Is the best ahead? Both are open-ended questions that solicit many diverse opinions but none that yields any clear answers. And no matter how good the thesis sounds about which way the market is headed, the future is forever unknowable.

Not knowing the future is hardly an endorsement for leaving your investments up to chance. Even during difficult economic periods, itís possible to achieve profitable results. Desirable results donít typically happen by accident, but out of deliberate action.

A quick glance of key indicators could signal the stock and bond marketís next big move. Letís analyze them.

Beware of a Low VIX
The VIX indicator has become a popular gauge of investor fear and complacency. Using a weighted blend of various S&P index options, the VIX attempts to estimate the implied volatility for the S&P 500 over the next 30 days.

What is the VIX telling us right now?

The VIX index is currently around 26.50, which isnít far away from its 52-week low of 20.10. This likely indicates that investors have become over-optimistic about future stock prices. A low VIX could also be interpreted as a sign that investors arenít fearful about a huge swing in stock prices. Conversely, an elevated VIX, as we saw last year, could be viewed as a sign that investors are overly pessimistic. 

The VIX concept was first introduced in a research paper by Professor Robert E. Whaley at Duke University.

Beware of Risky Assets
The fact that riskier assets have outperformed lower risk assets over the past seven months indicates an increased appetite for risk taking by the crowd. This is evident across multiple investment categories including industry sectors, global stocks and the bond market. View this as a contrarian indicator.

For industry sectors, volatile technology stocks (NYSEArca: XLK) have led most S&P 500 sectors in year-to-date performance. Within the global equity market, risky emerging market stocks (NYSEArca: EEM) have handedly outperformed stocks from developed countries. In the bond market, high risk junk debt (NYSEArca: HYG) yields and year-to-date performance have outpaced the investment grade bond market (NYSEArca: AGG). Instead of being a cause for celebration, increased risk taking should be a cause for reflection.

Ask yourself: Have I thrown caution to the wind? Am I taking too much risk in my own investments? Or, have I allowed the herdís mentality to pervert my perception of market risk?

Beware of Wolves dressed like Sheep
Entrusting your money to investment managers is no guarantee of success and sometimes results in full-blown disaster. Unfortunately, this caught millions of people by surprise.

In 2008, the Oppenheimer Core Bond A (Nasdaq: OPIGX) cratered 35.83% yet the Barclays Aggregate Bond Index as tracked by Vanguardís Total Bond Market ETF (NYSEArca: BND) climbed 5.17%. How long will it take Oppenheimerís bond fund shareholders to make up that 41% deficit?

A recently released study by Morningstar found that active management, when adjusted for risk, has lagged key market indexes over the past three years. According to the company, 63% of active mutual funds failed on a risk-, size- and style-adjusted basis. Why is this important?

While most portfolio managers would dismiss any three-year period as being significant, think again.

Because this particular three-year study encompasses both a bull market (2007) and a subsequent bear market (2008), it reveals just how bad active funds have underperformed during both market conditions. Most investors would do better by just investing in lower cost index funds and index ETFs.

Be Alert, Stay Vigilant
Nothing can be more dangerous to a soldierís safety than his or her own complacency. Sometimes when it appears everything is calm and safe is right when the enemy strikes! Take a look at  "5 Disturbing Facts for the Bulls" which discusses other key factors that illustrate the danger of irrational exuberance.

From an investment perspective, being inattentive, apathetic or lazy could cost you a bundle. Pay attention to risk indicators. They could tell us what lies ahead.

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