VIX and the Premature Return to Complacency
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Have You Seen This?

Have You Seen This?

It could be argued that the recent rise in the medium and longer term US Treasury rates have something to do with concerns re inflation. It also could just as easily be argued that a major part of the rise is due to a lessening of the fear factor related to the credit crisis and an associated narrowing of credit spreads. This latter point is debatable, however, as spreads have narrowed very modestly by most measures (see left chart for one example).

The same two part argument cannot, however, be attributed to the recent decline in the VIX. The drop from the high 20s to right around 20 implies a return to some degree of complacency by investors. This modest move to comfort seems to be premature as the future remains highly uncertain on a whole host of levels, not the least of which involves deleveraging, the changed business models of the credit creation machine, and the consequences therefrom.

Investment Strategy Implications

The importance of the VIX and credit spreads rests in their role as two key components in the risk adjustments made to valuation models. In my own Expected Return Valuation Model, the recent rise in the 10-year Treasury (along with the increase in equities) has had a large impact on the model, so much so that the US equity market now stands right around fair value.

The importance of getting the risk adjustment factor correct rests in its impact on the model and the fair value ranges produced. Therefore, gauging investor sentiment via risk appetite tools such as the VIX and credit spreads is vital to a more accurate valuation model. Accordingly, a conclusion re these risk appetite tools is necessary using other aspects of the equity valuation process and judgment. The conclusion reached here is one of skepticism re a return to complacency.

*To learn about the Expected Return Valuation Model requires a subscription. click here for more information. **click images to enlarge

Posted 04-24-2008 11:41 AM by Vinny Catalano, CFA
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