Cashing In On Panic

By Jason Goepfert

(Observer's note: this article led me to a very informative fellow blogger's website focusing on market volatility. I mark it here for my own reference - Bill Luby's blog site. The mid-term anxiety is killing me. ... I wish I could survive and then I'll reorganize my site to give it a nicer look.)

On the VIX and More blog, Bill Luby presented an interesting indicator this afternoon that takes a ratio of the VIX implied volatility gauge to the yield on the 10-year Treasury Note.

The ratio makes sense as a measure of fear or uncertainty in the market, since the VIX tends to spike higher during those times, while a rush to the safety of government debt tends to lower the yield on Notes. So when we see times of extreme duress, it should coincide with spikes higher in the VIX / Treasury Ratio.

The problem with the indicator is the limited history of the VIX. However, we can get around that by computing historical volatility on the S&P 500 instead - the two are very closely correlated. By doing that, we can get a history of the measure all the way back to 1962.

When doing that, we do indeed see that big spikes in the indicator have only occurred during panic situations. "Extreme" for this measure could be considered anything over a ratio of seven (meaning the level of S&P volatility is seven times greater than the yield on the 10-year Notes), and our current situation now qualifies.

The table below shows all dates when the ratio went from below seven to above seven. Note that there were some dates in fairly close proximity as the Note yield jumped around a bit at these times. Instead of removing them from the study, I included them so we could see all the dates.



We can see from the table that results going forward were exceptionally positive, and consistently so. Looking across the time frames from one week to three months, there were few negative returns, and the averages were several multiples of random returns during the study period. The combination of a high volatility level and low Treasury yield corresponded to some excellent buying opportunities over the past 45 years, with essentially no failures.