News was light on both sides of the pond yesterday, and investors took a breather. It almost seemed like a holiday week with low volume and a lack of market leadership. The biggest news was that Europe’s banks continue to ship money to the European Central Bank at a record pace, indicating that they have little incentive to put the money to work by lending to other banks.
And it’s no wonder the Europeans are fearful. Germany’s economy contracted by 0.25% in Q4, and Spain’s industrial output fell 7% in November, following a decline of 4.2% in October. And an auction of German government five-year paper was gobbled up despite a yield of under 1%.
Our market closed mixed with the Dow Jones Industrial Average off 13 points at 12,449, the S&P 500 was up fractionally at 1,292, and the Nasdaq gained 8 points to close at 2,711. NYSE volume totaled 758 million shares, and the Nasdaq traded 445 million. Advancers were ahead of decliners by about 1.3-to-1 on both exchanges.
In Tuesday’s Daily Market Outlook, we discussed the sentiment or contrarian indicators, one of which was the CBOE Volatility Index (VIX). This is often referred to as the “fear index” because it is based on a blend of various options on the S&P 500. Options prices tend to increase when more volatility is present and fall when uncertainty is low. This fear gauge is mostly used to identify tops and bottoms of markets.
I published this chart a couple of weeks ago in order to illustrate the influence of headline news on the S&P 500 in 2011. Notice the direct correlation to the big swings in the S&P 500 and the swings in the VIX.
The spring of 2011 was quiet until the Bank of England announced an inflation rate of 4%, and the Greece debt rating was cut to B1 followed by the Japanese earthquakes and tsunami.
But the real kicker hit when the U.S. rating was cut to AA+, and the VIX rocketed to the high of the year at 48 on Aug. 8, followed by the “out of box” error that drove the VIX up again. From Aug. 8 until the end of the year, investors were pummeled with one headline after another, and both the chart of the S&P 500 and the VIX illustrate the enormous swings.
The VIX has been criticized as having little predictive value. But it is useful in determining oversold and overbought market conditions. Note the relative complacency of the S&P 500 from April to late June when the VIX traded as low as 15 just before the June rally and then the market sell-off.
The high readings over 40 told us that the market was deeply oversold but that we should expect extreme volatility. And the last five months of the year turned out to be some of the most volatile on record with price swings directly tied to the latest European headlines.
Now, with the VIX back in the “complacency” zone, stocks have turned positive. The VIX is telling us that the recent breakouts are genuine but that the market will probably trade in a narrow zone much like the beginning of 2011. Nothing, however, can forecast the impact of bad headline news, and when that occurs, the VIX and every other indicator lose their predictive value and become followers.
After lagging the other indices, the small-cap Russell 2000 finally broke through its 200-day moving average. This confirms that the intermediate trend of the broad market has turned. But with such low volume, stocks could trade in a relatively narrow range for several months.
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