Amid the frenzy over the U.S. debt ceiling extension and the financial crisis in Europe some weeks ago, I thought the odds favored a significant rebound in stock prices largely because of widespread pessimism among market participants. With October's returns being among the highest on record, what is the mood among market participants now, and are stocks still attractive?
Not surprisingly, the sharp rebound in stock prices has lifted the mood of investors, as reflected by various sentiment surveys. One particular indicator of market sentiment is the VIX Index of option volatility. Low levels of the VIX indicate complacency among market participants, or even high levels of optimism. This condition does not, however, mean that a sharp market decline in imminent. Stock prices often have remained at high levels or risen even further when this condition has existed.
The converse has a much better predictive record. When the VIX Index is at high levels, it indicates high levels of fear, and such periods tend to be followed by a sharp rebound in stock prices. Specifically, when the VIX is above 28.5, the annualized return on stocks has been 39% on the S & P 500 going back to 1996. August was a good example, as the VIX was above 40. A sharp rebound in stock prices followed. When the VIX is below 28.5, the return on the S & P has been negative (excluding dividends). Today the VIX is at 29, right on the cusp.
For this and other reasons, I am neutral on stocks at current levels and recommend holding significant cash (outright or in high-yield bonds) in order to have ample resources for the next significant decline in stock prices.
S & P 500: 1276