Market Direction and Stock Trends

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3 lessons for stock investors from market’s wild ‘fear gauge’ spike in 2008
By: Mark Hulbert | November 14, 2017

Contrarians couldn’t have been much more wrong nine years ago

This week marks the ninth anniversary of one of the most momentous events in modern stock market history. And virtually no one is paying attention. I’m even willing to bet you didn’t have it in your calendar

I’m referring to the VIX’s spike in November 2008 way above its previous all-time high. The VIX VIX, +0.35% , of course, is the CBOE’s Volatility Index, otherwise referred to as the market’s “fear gauge.” Contrarians traditionally issue buy signals when the VIX approaches the high end of its historical range, since those levels mean fear is at an extreme.

Contrarians couldn’t have been much more wrong in November 2008. Prior to the spike in the VIX that month, the VIX’s all-time high was 45.74. So contrarian-oriented traders started buying when the VIX approached that level in early November 2008. Yet far from marking a bottom, the market kept on falling — and the VIX kept on rising. By the time the VIX finally hits its peak later that November, it was nearly double its previous record — 80.86.

Even worse from a contrarian point of view: The VIX’s peak above 80 was anything but a buy signal. Over the subsequent three months, until early 2009, the S&P 500 SPX, +0.10% dropped an additional 10.1% and the Dow Industrials DJIA, +0.07% fell 13.7%.

Nor are the past 12 months an exception, as you can see from the accompanying chart. Notice that, historically, there is hardly any difference in the stock market’s return subsequent to below-average or above-average VIX readings.



What are the investment lessons can we draw from this anniversary? I’ve come up with three:

· Past extremes are not sacrosanct. Just because the VIX had previously never risen above 45.74 didn’t mean it couldn’t rise even further. Just ask the investor who, in the fall of 2008, bought into the market when the VIX first hit its previous all-time high of 45.74: He had lost nearly 40% of his money by the time the market hit bottom in March 2009. Only follow indicators that stand up to rigorous statistical testing.

· When doing such testing, be careful to avoid “look-ahead bias.” We’re guilty of this when we assume we knew something at a crucial point in the past when, in fact, that something would have been unknowable until a later point in time. Today, for example,we have no way of knowing in advance what the VIX will be at the next bear-market bottom, but we can guess it will be a lot higher than it is today. But without such knowledge, there’s no way we can use that level as a buy signal.

· Base your indicators on a strong theoretical foundation. Most VIX-based models failed this requirement, even prior to 2008. After all, the VIX is not actually a fear gauge. It instead represents expected volatility — and, needless to say, there’s both upside- and downside volatility. Rigorous econometric tests of the pre-2008 data showed that VIX levels were not correlated with the market’s subsequent returns at even minimal levels of statistical significance.

The bottom line? If we can learn these investment lessons, perhaps the trauma of November 2008 will not have been completely in vain.

https://www.marketwatch.com/story/3-lessons-for-stock-investors-from-markets-wild-fear-gauge-spike-in-2008-2017-11-14

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