Preparing For Market Panic

“In the short run, the market is a voting machine, but in the long run, it is a weighing machine.”

This quote from Benjamin Graham means that over a long period of time, investors will analyze companies’ financials, competitive strengths, and management and accurately “weigh” what a company is worth. But in the short run, markets rise and fall, and investors experience emotions like relief, panic, and joy. In the short run, buying based upon these emotions is “voting.” During the dotcom bubble, investors voted stocks way up, and over time they weighed their value to bring stocks back down to earth.

As Facebook nears its IPO, the analyst and investment community will be busy weighing the value of its shares and trying to judge investor sentiment to arrive at a share price between $35 and $55. Over the long term, Facebook shares will receive a proper price, but in the short term, investor emotions will impact pricing.

What if computers could be made to read human emotion? Since most of us can fall prey to our emotions as we watch the market, what if we could measure market emotion and be ready for market swings? Look no further than the “VIX” index. VIX is a ticker symbol that you can track like a stock. Put it in your Yahoo finance ticker symbols and start watching it. VIX has a complex-sounding definition, but in layman’s terms, it measures fear in the market by the price of puts and calls on the S&P 500.

Consider insurance as a great metaphor. If you are older, term life insurance is more expensive than if you are younger because the risk is greater for the insurance company. Mutual and hedge fund managers make less money when they have big swings in their portfolios. Unhappy investors pull their money out of funds that have big ups and downs, which reduces assets and lowers fund manager salaries. They want to take their investors for a ride in a quiet, smooth Lexus, not around the track in a high-performance Porsche. So they buy insurance (puts and calls) to smooth out the ride. If the stock market is worried about Greek debt, U.S. deficits, and other matters, the price of puts and calls (insurance) goes up. That’s what the VIX measures.

When investors are incredibly relaxed without a care in the world, the VIX can get down around 10, as it was in 2007. During the height of the financial panic, it reached an unprecedented 80, and then it fell over a year following March 2009 to around 15 in May 2010 until the flash crash happened, and then it spiked back up to 45. It slowly declined to about 15 until last August when the world freaked out about the European debt crisis and our government’s impasse on the debt ceiling. The VIX has since calmed down and has slowly fallen back below 20.

In times like these, when the VIX goes down, it usually goes back up based upon a random and unknowable event. For the third time since the 2008 panic, the VIX has fallen down to a point where investors are so relaxed that they’ve left the office, gone to the spa, and are laying on a massage table. We don’t bet on markets, and our investment strategy is never to time the market. But if you want to get yourself emotionally prepared for swings, watch the VIX. If the past is any indicator for the future, we’re set up for another roller coaster ride soon.