Fear and Greed

Emotion Rules and we all know which emotion is ruling in the current market environment. It appears that no matter what bailout package is thrown at the market it is not enough. The US government eventually passed the $700 billion TARP package in an endeavour to shore up the US battered mortgage markets, but this will take weeks to implement. TARP stands for the Troubled Asset Relief Program and its objective is to allow the troubled US financial corporations to offload the toxic mortgages from their balance sheets.

The US government has also stepped in to try and resolve the credit market freeze, and to offer support for the functioning of the commercial paper market. This will allow companies to get access to credit in order to build their businesses going forward.

The co-ordinated interest rate cuts across every continent were initially met with buying, but investor panic re-emerged quickly across all markets as traders reassessed the poor prospects of the global economies. Those traders and investors looking for signs of a market low will be looking for:

• Stretched market valuations;
• Stocks making 52 week lows;
• Fear Gauge;
• Bad news discounted into the market;
• Capitulation.

My current market assessment of these measures is as follows:

Stretched market valuations
- At current valuations the Aussie market is factoring in a 40% decline in earnings per share going forward, some would suggest this is excessive.

Stocks making 52 week lows
- The number of stocks making 52 week lows has reached a level we have not seen since early 1Q 2002 and prior to that we have to go back to mid 1998 to see these levels. On both of these occasions the markets saw a significant turnaround not long after.

Fear Gauge
- I will use the Volatility Index (VIX) for this (see the discussion to follow).

Bad news discounted into the market
- At this stage both good and bad news are still driving markets lower.

Capitulation
- This is signalled by an exhaustion gap and a huge spike in volume in the prevailing direction of the trend, as stock ownership passes from weaker hands to stronger hands. It will be interesting to see if this unfolds in this market given the steady grind of the markets since last November.
- Trading volumes have been very low during the northern hemisphere summer trading season, but they have been picking up over the last couple of weeks.

Measure of Fear

A fear gauge that has proven reliable in the past is the Volatility Index (VIX).

The VIX is the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. It is a measure of the market’s expectation of volatility over the next 30 day period. Historically the VIX hits its highest levels during times of financial turmoil and investor fear. As markets recover and investor fear subsides, VIX levels tend to drop.As stated in the CBOE Volatility Index white paper:“VIX is based on real-time option prices, which reflect investors’ consensus view of future expected stock market volatility. Historically, during periods of financial stress, which are often accompanied by steep market declines, option prices – and VIX – tend to rise. The greater the fear, the higher the VIX level. As investor fear subsides, option prices tend to decline, which in turn causes VIX to decline. It is important to note, however, that past performance does not necessarily indicate future results.”

This effect can be seen in the VIX behaviour isolated during the Long Term Capital Management and Russian Debt Crises in 1998. As the chart illustrates, the VIX spiked to its peaks as the market suffered through steep declines in August and October 1998, and then rallied through the end of November.

The VIX gauge is now at historic highs, which is understandable as the VIX measures market expectations of near term volatility conveyed by stock index option prices. If history repeats then we may well be coming close to a market low.

What should investors look for to confirm a bottom?

• A 3-day, then weekly, then monthly close above the previous relative high.
• The 9, 21 and 50 days moving averages turning up.
• Overseas markets settling
• Positive response to the implementation of the $700 billion TARP package
• Positive impetus from the coordinated global rate cuts
• Positive response to removal of the Shorting Bans

Note that historically market lows are often formed in the later part of October and generally the best six months of the year to be invested are November through to April. This upward bias from November through April, combined with a market bottom may provide traders with a profitable opportunity for a bear market rally into the earlier part of this year.

MDS Financial maintains offices in Sydney, Melbourne and the Gold Coast and NISER can assist local businesses or individuals contact them. Sean Rothsey is Executive Chairman of the ASX listed diversified financial services company MDS Financial Group Ltd. (MWS: ASX). He works in Cooroy and lives in Sunshine Beach.

If you would like to discuss these issues further please contact Sean Rothsey at niser@niser.org.au or 5442 5050 or your own financial advisor or visit www.mdsfinancial.com.au

I collated this for your information from The Cube Financial Group Pty Ltd AFSL 232455 (“Cube Financial”) a subsidiary of MDS Financial Group Limited with the following disclaimer: This information is prepared for the general information of traders and investors. The information does not take into consideration the specific needs, investment objectives or financial situations of any person. Any individual reading this should discuss, with their financial planner or advisor, the merits of any recommendation or offer presented in this material for their own specific circumstances and realise that not all investments are appropriate for every individual.

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