The Fear Bubble (10/08)

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Tuesday, 04 October 2011 10:31 Written by James Van de Voorde

"The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown." - H.P. Lovecraft, U.S. Poet (1890-1937)

With the precipitous drop across all major global equity indices, investors are rightfully concerned and asking why markets have fallen so far, so fast.  To be sure, the nationalization of Freddie Mac and Fannie Mae, collapse of Lehman Brothers, conservatorship of AIG and failure of Washington Mutual and Wachovia are all major events by themselves.  To have such (formerly) mighty institutions all fall within such a short period is unprecedented and nothing short of shocking.  Given all the bad news that has surfaced during the last 30 days, we certainly cannot fault investors for feeling frightened.  Borrowing from the above Lovecraft pearl, the situation is made more fearful because there seems to be so much that is simply unknowable.  Yet the fear that has engulfed the market has turned to outright panic and now may be in a bubble of its own.

The Chicago Board of Trade Options Exchange Volatility Index (VIX) is calculated based on the implied volatility of options (puts and calls) on the S&P 500 and reflects investors’ consensus for expected volatility in the stock market over a 30-day period.  The VIX and the S&P 500 tend to have an inverse relationship, with the VIX spiking upward when the stock market posts sharp losses, reflecting bearish consensus and growing fear that losses will continue.  For this reason, the VIX is widely known as a gauge of investor fear and a useful tool in analyzing market sentiment.  The fact is that markets have always made significant bottoms when fear is at its maximum peak.  Consider the following chart (stockcharts.com), which illustrates the parabolic rise in the VIX over the last month and its inverse relationship with the S&P 500:

It may be difficult to read, but the VIX spiked to a read of 57 as of the posting of this chart and even reached an intraday high just under 75 on October 10^th.  The VIX at 75 is the highest read of investor fear since the stock market crash of 1987.  Again, this type of spike in fear has marked every single major market bottom of the past 30 years.  To say that the VIX has reached an unsustainable parabolic rise may be an understatement – it has risen 230% from a low of 22.64 in only 30 days!     

This parabolic rise supports the case that fear may be in a “bubble” of sorts, not unlike the recent oil bubble.  Since reaching a parabolic high of $147, oil has settled down below $90.  We fully expect that the measures currently being undertaken by the Fed, Treasury and Monetary Authorities worldwide will eventually have a calming effect on the credit markets and lead to a subsequent decline in fear, an easing in the VIX and reversion to the mean for the stock market.   

Much of the fear resonating today stems from comparisons of current economic conditions with that of the Great Depression.  We’ll make the comparison and invite you to make your own conclusions.  During the Great Depression, GDP fell 30%, unemployment reached as high as 35%, 40% of Americans faced foreclosure and industrial production fell 50%.  While we recognize that economic conditions will deteriorate in the coming quarters, the latest quarter showed GDP up 2.8% on an annualized basis, unemployment at 6.1%, foreclosures at 4% of all mortgages and industrial production down only 1.5% from last year.  And the Depression was exacerbated by government “solutions” which included tight monetary policy, Smoot-Hawley protectionism and a laissez-faire attitude towards bank failures. Fed Chairman Bernanke is a student of the Great Depression and his policy measures thus far offer a stark contrast to the failed policies of the Hoover administration.  Fitting for this comparison with the Great Depression and perhaps another contrary sign of a bottom, the current cover of Time magazine titled “The New Hard Times” pictures a Depression Era cue of the down-and-out lined up to receive “free soup”. 

Still other contrary indicators include the temporary halt of the sale of 24-karat gold coins by the U.S. Mint due to soaring demand, the AAII Investor Sentiment Survey which now shows a very lopsided read of 55% bearish and only 33% bullish, and CNBC’s Jim Cramer instructing his minions to “sell”, not on his Mad Money program but on the Today Show no less.  Keep in mind that this is the same Cramer that told followers to “buy, buy, buy” Wachovia only days before its collapse.  And cash in money market funds on the sideline at $3.5 trillion could buy over 40% of the entire S&P 500 at current prices.     

While Cramer is telling traders to sell into a panic, Warren Buffet has committed $34 billion of fresh capital to the stock market in the last 30 days by acquiring Constellation Energy and taking significant stakes in both Goldman Sachs and General Electric.  Meanwhile, insider buying is showing a dramatic rise and the second largest pension fund CALPERS announced that they were buying stocks in the current environment.  This seems like a clear case of the smart money taking advantage of a truly rare opportunity. 

The Osher investment philosophy is based on much of the long-term principles espoused by the legendary Warren Buffett.  We buy good growth businesses at a favorable price and do not try to time the market.  However, there are periods when the market prices the businesses we own at a steep discount to their intrinsic value.  We believe this is one of those times – stocks across the board are selling at bargain prices.  We know it’s difficult, but we need to remain laser-focused on our long-term investment goals and not succumb to the fears of the day.