Stock Market Volatility

If you have kept your eye on the stock market lately you may have noticed that it has been extremely volatile. Just within the past week the S&P 500 has closed up 4.20% and had two days where it closed down by more then 2.00%. Below is a chart of the S&P 500.

Source: finance.google.com

Volatility Index

A way that this volatility can be measure is by the VIX, Volatility Index, which is a benchmark index driven by option prices on the S&P 500. The index was developed by the Chicago Board Options Exchange in 1993 and is based on real-tme option prices and measures the expected near term (30-days) volatility of the market. The CBOE explains the index as follows:

VIX is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility. During periods of financial stress, which are often accompanied by steep market declines, option prices - and VIX - tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline.

Below is a chart comparing the VIX to the S&P 500 back to January 1990. It is interesting to see the relationship between a decrease in the VIX and increase in the S&P 500 on the last third of the chart. For the past several years, the market has experienced a period of relative calm, or the "Great Moderation." This was a period of time marked by easy credit, real estate became the next bubble, and investment banks developed all types of synthetic securities. It seems that risk left the vocabulary of investors.

Source: cboe.com/VIX

Are We Entering A Period Of Renewed Volatility?

The WSJ had an article which discusses "Great Moderation" and the possibility that we may be entering a period of volatility. The article provides a nice analogy of risk.

That raises the question of whether the idea of a Great Moderation led to its own undoing. As volatility fell, risk-hungry investors and trigger-happy policy makers spent a lot of time patting themselves on the back. Fed officials talked up a more rosy economic landscape and confidently pushed interest rates to historic lows, sure they could fix any problem. Investors witnessed it all and made riskier bets, depending on ever-more debt, to boost their returns.

The compression in volatility was like pushing down on a spring. Now it's sprung. We're probably in the second recession this decade. And the Fed is lowering rates again.

What Is The Average Investor To Do?

For most average investors, there probably isn't anything that you should do. Hopefully, you have determined the level of market risk your are comfortable with and have allocated your investments appropriately. If you have an automatic investment purchase plan set up and a longer time horizon, enjoy the opportunity to buy additional shares at cheaper prices.

If your approaching the time when you will need your money and our uncomfortable with the volatility, look to move your money to more secure investments. With the Fed dropping interest rates, most savings accounts, money market accounts and CDs are barley beating the inflation rate. One option might be to invest in Treasury Bonds or dividend paying stocks. One of the great things about stocks that pay a nice dividend, is that you get pay to wait for any capital appreciation.

Source:
http://www.cboe.com/micro/vix/introduction.aspx
http://www.cboe.com/micro/vix/vixwhite.pdf
http://www.cboe.com/micro/vix/pricecharts.aspx
http://online.wsj.com/article/SB120588597399047123.html?mod=todays_us_money_and_investing {$$$}