Investors Hit by Big “Volatility Stick”

Investors Hit by Big “Volatility Stick”



By: Clif Droke, Gold Strategies Review


-- Posted Thursday, 30 August 2007 | Digg This Article


The year 2007 has proven to
be one of the most volatile years in recent memory. You’d have to go
all the way back to 2003 when the last bear market ended to see a
similar level of market volatility as measured by the Volatility Index
(VXO).
Volatility is most common at the
end of a market decline or correction. It’s really a combination of
factors: the public, in typical reactionary fashion, gets scared and
panics as the end of the correction approaches. They throw everything
overboard and completely unload their stock holdings. Making matters
worse (for them), they begin heavily buying put options and selling
stocks short based on the mistaken belief that things can only get
worse. Volatility increases and is a reflection of the amount of fear
investors have about the future.
More
than anything else, volatility is a measure of the three dominant
emotions that investors experience: fear, greed and complacency. It’s
when the most dominant of these emotions, namely fear, is at a peak
that huge spikes in the Volatility Index are seen like the one recently
(see chart below). These volatility spikes, while usually short-lived,
tend to feed on themselves and create even more fear and panic among
retail investors. The fear is further augmented by the massive exposure
given to volatility in the mainstream financial press. One could
advance the argument that the press has helped create the volatility by
its incessant campaign of headline fear which it has waged virtually
non-stop this year.


Too
many investors have been under the media’s spell as these investors
have been too scared to take advantage of the two great buying
opportunities the market has presented them with this year. The first
one was in March and the other in August. This really isn’t at all
surprising given that most mainstream investors are under the control
of the media, psychologically speaking (see Lonny Kocina’s book, Media
Hypnosis, for a more in-depth discussion of this concept of media mind
control). As Don Hays puts it, "The news is the camouflage that drives
the herd crazy."
Volatility is also used as
a weapon against mainstream investors. It can be used, for instance, to
clear small investors out of the way so that big money traders can
scoop up shares at bargain prices. Most small investors simply can’t
afford a prolonged exposure to market volatility and are often forced
to sell out to the big money traders, who in turn are more than happy
to relieve the small traders of their shares at cheap prices.

From
a psychological standpoint, volatility has been shown to increase
anxiety and paranoia in most investors. It makes them more likely to
let go of a potentially profitable long position at the slightest hint
of weakness. Ironically, this helps bolster the stock market’s support
since an increase in worry has been shown to strengthen the market’s
"Wall of Worry." It comes as no surprise then that the recent market
bottom was been accompanied by a huge increase in bearish sentiment,
worry and volatility. It’s as if investors have been collectively hit
by a big "volatility stick" and are afraid to go anywhere near the
stock market.
Carl Swenlin of
Decisionpoint.com points out that with the recent change to the "up
tick rule" on short selling this summer, there was a corresponding
increase in volatility. This may account, at least in part, for the
severity of the recent correction. Swenlin also points out that this is
a "two-edged sword" that can magnify the severity of a decline by
allowing short sellers to sell into it. But it will also tend to
produce a greater number of short sellers who can be "squeezed" when
the short interest builds too much. To give you an idea just how much
the public short selling has increased lately, take a look at the
following chart.

One
of the biggest moves in the major indices was accompanied by a huge
move in the Volatility Index recently. As mentioned earlier, the CBOE
Volatility Index (VXO) can be used to measure short-term spikes in fear
and complacency in the stock market. A huge rally in the VXO such as
the one we saw in the past two weeks normally precedes important
correction lows. The latest spike in the VXO, the highest since 2003,
is one of many signs that the market has overdone the fear-driven
decline and now an important bottom is being made.
To
underscore the point I’ve been trying to make that the most important
role of market volatility, let’s discuss the correlations between
volatility increases and insider buying of stocks during market panics.
Other than the obvious benefits that increased volatility confers to
insider traders in making short term capital gains, it can also be used
as a weapon to scare away the small investors from participating in a
market uptrend as we’ve looked at here. Additional proof of this is the
comparison that can be made between the Gambill Oscillator, which
measures insider buying, and the Volatility Index.
The
Gambill Oscillator tracks corporate insider activity in the Russell
3000 stocks. Along with the VXO, the Gambill Oscillator is showing the
highest level of insider buying since the March 2003 bear market low.
Since 2002 when this indicator was first created, whenever the
oscillator went above 25% (which it did in the latest correction), the
stock market was up over 10% in the coming six months and up 22% over
the next year. The Gambill Oscillator hit a high reading of 75% during
the broad market decline.
Another point
worth making is that since 1990, whenever the Volatility Index has been
between 30 and 40, as it was during the recent correction, the stock
market has been up by an average of nearly 11% over the next six
months. Moreover, the market’s gains over the following 12 months has
been an average 16.2%. This compares with average "normal" market
returns of 4.8% and 10.2%, respectively, over the 6-month and 12-month
time frames.
Bolstering this bullish stock
market outlook based on the insider sales data is a recent report by a
respected financial newspaper. According to the Financial Times, total
insider buying in the U.S. stock market reached $252 million in August,
the highest level since 2003. This compares to a seasonal average of
$186 million. At the same time, insider sales have dropped sharply from
a four-year monthly average of $4 billion to $2.9 billion.
Volatility
can indeed be used as a "big stick" to hit small investors with and
send them running for cover. But this stick has two edges and the end
result of the recent volatility spike will be positive for stocks.
Clif
Droke is the editor of the three times weekly Momentum Strategies
Report newsletter, published since 1997, which covers U.S. equity
markets and various stock sectors, natural resources, money supply and
bank credit trends, the dollar and the U.S. economy. The forecasts are
made using a unique proprietary blend of analytical methods involving
internal momentum and moving average systems, as well as securities
lending trends. He is also the author of numerous books, including
"Moving Averages Simplified." For more information visit www.clifdroke.com