meandering monday, page-4

FEAR GAUGE POINTS TO US STOCKMARKET RALLY

Excerpts:

...........Despite the VIX's popularity, it is a watered-down usurper. Today's VIX was created in September 2003 to replace the classic VIX, which is now known as the VXO. That original VIX only looked at options for the elite S&P 100, the top 20% of S&P 500 companies. And it only used at-the-money options. While this methodology lives on in the VXO, the new VIX changed how it is calculated. Today's VIX considers options for the entire S&P 500, including out-of-the-money ones. This makes it less responsive to fear.

This is a problem for a fear gauge. During sharp selloffs that spark intense fear, the first stocks to be sold are the biggest and most-liquid ones. They have the large volumes and liquidity necessary to absorb the widespread exodus of capital without suffering anywhere near as much price damage as smaller less-liquid companies. And at-the-money options' prices are always quicker to respond (with bigger moves) than out-of-the-money ones. So while the new VIX works, the classic VXO remains superior............

....The bottom line is stock fear has a ceiling, and that is represented by a 50ish VXO. While this ceiling won't hold during panics and crashes, those ultra-rare once-in-a-generation events aren't worth worrying about the vast majority of the time. Normally whenever the VXO surges to 50, it is time to buy aggressively as fear has peaked so a huge stock-market rally is imminent. This is true in secular and cyclical bulls and bears alike.

And just a few weeks ago, the VXO once again slammed into this effective ceiling. Fear was incredibly intense, with perma-bears, chicken littles, and pessimists coming out of the woodwork to call for a continuing stock plunge. But market history clearly shows that expecting the stock markets to head lower after a fear-ceiling approach is almost never the right bet to make. Extreme fear should always be bought.