Wednesday, August 24, 2011

The role of fear

This chart compares the behavior of the S&P 500 index (orange) to the Vix index (white). The correlation between the two has been almost perfectly negative: -0.95. Which is to say that the recent declines in equity prices this year have been accompanied almost exactly by rises in fear, uncertainty, and doubt. Perhaps in the fullness of time we will see that declining equity prices were a response to a deterioration in the economic fundamentals, but for now the only thing that is clear is that the decline has simply been the flip side of a rise in sheer terror. As I've suggested before, the terror is likely being sparked by concerns that a PIIGS default could wipe out the European banking system and that, in turn, could bring down the entire global economy. Were these fears to be allayed for whatever reason, it follows that global equity prices would enjoy substantial upside gains. To get a rally, we just need to avoid a catastrophe.

For a more detailed explanation of how big Vix spikes have tended to come in pairs, to be followed by equity rallies, I refer you to this post at Vix and More. For more insights into how the Vix index works, see this post.

Meanwhile, here's an update on the source of all these fears. A significant Greek default is now all but certain (we've known this since at least last April). The risk of contagion is reflected in Portguese and Irish bonds, but together they owe a bit less than Greece does ($500 billion), and their chances of default are substantially less: Greece CDS today are trading at 2300, while Portugal and Ireland CDS are 1060 and 866, respectively. Italy and Spain CDS are trading around 380, which is equivalent to the low end of investment grade corporates. So catastrophe—which would take the form of a meaningful default on Italy's $2.3 trillion debt—is far from imminent.

1 comment:

Benjamin Cole said...

I suppose making any calls based on one day of action is now officially crazy. Don't like the market today? Come back tomorrow, it will be going the opposite direction.

But the gold sell-off: Good news?