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| | The Speculator
The market's shaken, rattled and ready to roll
A key measure of market volatility, the VIX, is shooting up. That means pessimism is nearing a peak -- and that's a good time to buy.
By Victor Niederhoffer and Laurel Kenner
We have been bullish for two weeks now, and the market has had a fourth and fifth week of declines. Are we giving up? No.
People forget that the market can go up when it has been declining for a while, just as they forget it can fall after a prolonged rise. As everyone knows, its always darkest before the dawn. There is no measure for darkest, of course, but the market has sent a buy signal thats the best we have found.
This signal is the Chicago Board Options Exchanges Volatility Index, commonly referred to as the VIX ($VIX.X). The concept is that when VIX is relatively high -- above 30 -- sentiment is unusually pessimistic and prices are down. Because a high VIX reflects the higher rate of return demanded by investors, its a good time to buy. Conversely, when VIX is relatively low -- below 25 -- sentiment is optimistic and its a good time to sell.
We wrote about our tests of this measure in our May 3, 2001, column, Make volatility and uncertainty your friend. The systems efficacy was borne out in subsequent months, when using it would have resulted in two profitable trades.
In a nutshell, you buy financial instruments that mimic the movement of the S&P 500 index the first time the VIX closes above 30. You sell when the VIX closes below 25. Such instruments would include S&P futures contracts, S&P Depositary Receipts (SPY) or a mutual fund such as the Vanguard 500 Trust (VFINX).
Volatility hits a high
Last Thursday, June 20, the VIX closed at 32.5. This was its first close above 30 since we closed out our last VIX trade on Nov. 23, 2001.
We have therefore started buying the market, augmenting our bullish position in the individual stocks we mentioned buying in our May 13 column (Foil the money-snatchers: Buy a stock).
We have updated the results of our May 3, 2001, VIX Swing System study with the two additional trades that came after publication. The table appears below:
| VIX Swing System | | Tale of the trades | | | | | | Date | VIX | Buy S&P 500 | Sell S&P 500 | Chg. | | Oct. 27, 1997 | 39.96 | 876.99 | | | | Dec. 1, 1997 | 24.88 | | 974.77 | 11.10% | | Dec. 24, 1997 | 30.47 | 932.7 | | | | Dec. 30, 1997 | 24.93 | | 970.84 | 4.10% | | Jan. 9, 1998 | 34.46 | 927.69 | | | | Jan. 14, 1998 | 24.21 | | 927.94 | 0.00% | | Aug. 4, 1998 | 33.1 | 1,072.12 | | | | Nov. 5, 1998 | 24.8 | | 1,133.85 | 5.80% | | Dec. 14, 1998 | 32.47 | 1,141.20 | | | | Dec. 18, 1998 | 24.66 | | 1,188.03 | 4.10% | | Jan. 13, 1999 | 31.26 | 1,234.40 | | | | Mar. 8, 1999 | 24.98 | | 1,282.73 | 3.90% | | Sept. 23, 1999 | 30.28 | 1,280.41 | | | | Oct. 6, 1999 | 23.53 | | 1,325.40 | 3.50% | | Oct. 15, 1999 | 31.48 | 1,247.41 | | | | Oct. 21, 1999 | 24.77 | | 1,283.61 | 2.90% | | Apr. 5, 2000 | 30.59 | 1,487.37 | | | | June 1, 2000 | 24.74 | | 1,448.81 | -2.60% | | Oct. 11, 2000 | 30.95 | 1,364.59 | | | | Jan. 23, 2001 | 23.86 | | 1,360.00 | -0.30% | | Feb. 28, 2001 | 31 | 1239 | | | | May 18, 2001 | 24.26 | | 1,291.96 | 4.30% | | Sept. 6, 2001 | 32.48 | 1,103.50 | | | | Nov. 23, 2001 | 24.78 | | 1,153.00 | 4.50% | | June 20, 2002 | 32.5 | 1,007.10 | | | |
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| Swing System results | | 10 out of 12 wins | | Average Return/Trade | | 3.40% | | Standard Deviation | | 3.40% | | Total # Trades | | 12 | | Total # Trades With Gain | | 10 |
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When a patient is very ill, as is the case with the market, its wise to obtain a second and third opinion. And weve done that. The second opinion comes from the Buyback Letter Index, which adds several bullish percent series together (Investors Intelligence, Consensus Index, AAII Index and Market Vane as reported in Barrons) and averages them. For the last several years, market lows occurred below readings of 130, while tops came north of 200. The index is around 127 now.
For our third opinion and last word, we turned to the one man we trust more than anyone else in the financial world: Jim Lorie. He was Vics doctoral thesis adviser at the University of Chicago and founded the universitys Center for Research on Securities Prices, the best database of U.S. stocks. He sits on many boards and has invested with happy results over several decades, through boom and bust. He has seen it all, and he passes along his insights without bombast or pretense. If anyone fits the definition of a clear thinker, Lorie does. In addition to all these outstanding qualities, he is a second father to both of us.
When Vic popped the question about where the market will go, Lorie answered as follows: The market will go up like it always has in the long term. But in the short term, who knows?
No one, well venture to say, can do better than that.
Waiting for the new growth
Lorie recommended Dinesh DSouzas "Whats So Great About America" as a great insightful tome for a rainy day. Its worth noting that "Triumph of the Optimists, the study of world markets in the 20th century by Elroy Dimson, Paul Marsh and Mike Staunton that we have cited extensively in our columns over the few months, found that the highest world returns over the century were achieved by the countries that most consistently embodied political freedom. We plan to take DSouzas book along with us to read in our spare moments as we proceed through coming days, and were sure that readers will find it beneficial as well.
Whenever we find ourselves on the knifes edge, we find that there is nothing better than a walk outside in nature. Vic paid a visit to the New York Botanical Gardens in the Bronx on Saturday, and observed in the conservatory a big display of lush plants growing on the fallen branch of a dead tree. The new plants dont need roots or earth -- just light.
We wonder what the many companies that will grow on the dead branches of the market are. We are impatient to see them. We dont know when they will come -- but we know they will.
At the time of publication, Victor Niederhoffer and Laurel Kenner owned none of the securities mentioned in this column.
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