Take a ride on the fear express!
The VIX, a key measure of panic and fear, hit a record high Thursday. Is that a sign that the market is in for more bad news or that it may have finally hit bottom?
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| The CBOE Volatility Index, or VIX, is a key measure of how jittery investors are....so it's no surprise that the VIX has soared while the market has plummeted. |
NEW YORK (CNNMoney.com) -- There is a ride at the Six Flags Great Adventure theme park in New Jersey called the Great American Scream Machine. Rumor has it that it will soon be renamed to give it a much more frightening moniker: The Dow.
Of course, I jest. But the market's gut-churning volatility of the past few weeks makes it seem like Wall Street is one big roller coaster. And not surprisingly, many investors are afraid.
There's even a way of measuring that, an index on the Chicago Board Options Exchange known as the CBOE Volatility Index, or VIX.
The CBOE describes the VIX as a "key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices." But many in the financial press have taken to referring to it as Wall Street's "fear gauge."
That may not be technically accurate but it's close enough. The VIX (VIX) has more than tripled since the end of August and has nearly doubled in just this month. The VIX tends to surge on days when the market is plunging and fall on days when stocks are rallying.
To that end, the VIX plunged 21% on Monday and soared nearly 26% Wednesday. It hit a record high Thursday morning when the Dow was down nearly 400 points and it was starting to look like stocks would suffer their second consecutive bloodbath.
The VIX bounced back a bit later in the day once stocks rallied. But the VIX rose 4% Friday as the stocks fell on yet another topsy-turvy day.
So how important is the VIX really? Can it give investors more than just a daily snapshot about how terrified people are?
It can. In fact, some argue that when the VIX is near record levels, it could mean that the market is nearing its lows.
"Short-term direction of the market is always difficult to predict but the VIX is a valuable tool of showing when there is real panic and fear in the market," said Alan Skrainka, chief investment strategist at Edward Jones in St. Louis.."It is, with all the appropriate caveats, a pretty good indicator of market bottoms."
Skrainka pointed out that, typically, a VIX level above 30 is considered a sign of fear. To put that in perspective, the VIX closed at around 70 on Friday.
He noted that in the late summer of 1998, when hedge fund Long-Term Capital Management was imploding, the VIX had a stretch where it routinely was in the low to mid 40s. But stocks went on to have a big rally in the fourth quarter of 1998 and through 1999.
Still, the VIX is hardly foolproof. Investors did party like it's 1999 in 1999 but the next three years were brutal.
The VIX was above 30 in April 2000 when tech stocks were crumbling and that was not a market bottom. The VIX shot up above 40 again in the wake of the September 11 terrorist attacks. That wasn't the bottom either.
The market didn't bottom in the last bear market until October 2002. But in the months preceding that, the VIX was often above 40. That period was the height of the accounting shenanigans that shattered investor confidence -- WorldCom filed for bankruptcy in July of that year.
So clearly, just because the VIX is rising sharply doesn't mean that it can't keep rising. After all, the VIX was in the 40s just a few weeks ago and stocks have kept falling.
Todd Salamone, senior vice president of research with Schaeffer's Investment Research in Cincinnati, points out that other measures of volatility, most notably the 20-day historical volatility of the S&P 500, have also been on the rise.
That figure is currently at about 80 and Salamone said that the VIX could trade as much as 35% higher than this number before it's really a market bottom. That implies that the VIX may need to hit about 108 before the worst is truly priced into the market.
"You can't view the VIX as just a fear index," he said. "Yes, the VIX is elevated but so too is historical volatility. The VIX indicates fear but the jury is still out on a bottom. You probably still need to see more panic."
In other words, people may get even more fearful in the months to come. And the current problems facing the financial sector dwarf the LTCM debacle and Enron-WorldCom-Tyco book cooking.
Yes, there are some tentative signs of hope in what continues to be a dismal period for the markets and economy. Warren Buffett, the legendary investor, wrote in an editorial in The New York Times, Friday that he is personally buying stocks even though he thinks "headlines will continue to be scary."
That's yet another indication from Buffett that he thinks there are good values in beaten-up companies -- in the past few weeks, his Berkshire Hathaway (BRKA, Fortune 500) firm has announced that it is buying stakes in General Electric (GE, Fortune 500) and Goldman Sachs (GS, Fortune 500).
Buffett is obviously giving people the right advice about investing, that you need to take a long-term view and that at times when everybody assumes the worst, it's usually the best time to buy.
But Salamone cautions that it may still be too soon to jump back into the market right now unless you are willing to endure even more big drops.
"There are instances when the VIX goes up to a historical level and it's a buying opportunity but it doesn't look like we are there yet," he said. 
