Thursday, December 15, 2011

The Fear Roller Coaster - Are We There Yet ?

I always take with a grain of salt all the chart comparisons showing why something in the markets must happen just because it happened that way before. Most of the time, it seems the macro-economic fundamentals are so different between the two cases that a comparison isn't very predictive.

But there is an element of market truth in George Santayana's general wisdom "Those who cannot remember the past are condemned to repeat it". When similar fundamentals are working on the investor psyche, a repeating market pattern can be as unchanging as human nature.

With that in mind, a stunning fear comparison can be drawn between the human reactions to the events surrounding the mortgage meltdown of 2006 to 2008 and the evolving Euro banking crisis we have before us. Both of these involved the development of a 4 year bull turning back into a larger bear trend. Going into 2007, we had climbed up from the 2003 bottom, but ran into the US mortgage mess. Now, it's been nearly four years since the 2008 bottom (most markets bottomed in '08) and we are again running into a banking mess, only this time it's in Europe. Investors fear banking problems more than anything. It screws up and brings to naught everything else.

Art Cashin's 12/15 CNBC interview expresses this fear well. Cashin mentioned the "roller coaster" ride of the VIX index, the market's main measure of fear. In trying to explain why the VIX has receded below 30, more or less the panic threshold, when we have plenty to panic over, he said that perhaps the VIX was "fatigued". It was suggested that maybe the FXE, the Euro index, would be a better measure of fear now. But "fatigue" sounds suspiciously human in nature, and not something a carefully crafted index would be prone to.

The receding VIX seems nice. It's been suggested that this is a market tell that everything is getting fixed in Europe and that we shouldn't argue with it. Just be thankful and go long. But the Cashin interview pointed out the worry-some problem well. Europe doesn't have the hand-in-glove management of Geihtner and Bernanke in the '08 US banking crisis. They don't have a fire department to put out the flames. They don't even have a fire code. A quick fire hose on any surprise banking problems? "That's not going to happen over there" was Cashin's take. We sometimes think of Europe's problems as a junior version of the US problems by belittling a country's GDP with a comparison to the GDP of Rhode Island or whatever. But the truth is, Europe's total banking assets is four times that of the US. So an equivalent out-of-control blaze over there would be four times as big a mess.

So what's all the complacency about in the VIX ? Well, you could argue it's just human nature. And if it's human nature, it is as predictable as the sun rising in the morning. Let's take a look at a side by side time-line comparison of fear as measured by the VIX over the course of the 2006-2008 roller coaster and the 2010-2012 roller coaster. The major events are noted with the resultant market fear reactions: (click on image, then right click on this image and select "view image", then click on this image to magnify)

Those of us who believe the markets are a fractal beast could point to this in the Exhibit A collection. Except for the artificial interference of QE, the two roller coasters seem to have been built per the same plans. The same plans perhaps have something to do with the same human DNA involved. We panic when at first presented with a frightening problem. The problem doesn't go away, but our fear level must recede. We are not programmed to stay very scared for very long. Our fear gets fixed before the problem does. As humans, we can all relate to that in our non-market psychology as well.

The large fear reactions, the runs to over a 30 VIX, not only occur in the same time sequence in reaction to similar developments over these two banking scares, they form almost identical topping patterns before they recede. And the overall trend as shown by the 140 day moving average (blue line) runs the same course except for the QE 2 period. However, within this QE 2 period, the fear spikes transpire in the same manner - just at a muted amplitude, until the medicine wears off.

Of note is the apparent loathing of fear that sets in after each huge bout of it. The underlying, structural problems are not fixed, but there are always some compelling positives to avert our gaze to. We get "fatigued" by fear as Cashin phrased it. It's purely human. So, is our current relaxing of the VIX a market tell that everything is indeed getting fixed in Europe and that we shouldn't argue with it? Should we just be thankful and go long? Well, in the context of the above comparison, which clearly shows this same exact complacency pattern after a significant market top and just before the harrowing slide of 2008 - I'd say let's call it fatigue, false bravado, foolishness, or anything but the truth.

Speaking of market tops, this fear progression played out in precision timing with the rises and falls of the S&P 500 over these two roller coaster rides. If you do the same side by side time-line comparison as above, you see another matched set:(click on image, then right click on this image and select "view image", then click on this image to magnify)

There were relatively small initial reactions by the market to the approaching crises - the end of the housing boom in 2006 and the end of QE 1 in 2009. These both were turned back to the upside with the very similar head and shoulders turns, then both went into the big tops with very similar head and shoulders turns back into bear markets. The current receding of the VIX below 30 has to be called the complacency before the storm - unless some "bazooka" from the Europeans is strong enough to knock our car off the tracks. A bazooka, firehouse, or some draconian surprise may have to blast us, or - to answer our kid in the back seat - we will be there.

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