Measuring fear

Last week’s post looked at consumer confidence. This week, we’ll look at a confidence measure of a much more specialised nature. But first, here’s a little background.

In October 2008, at the height of the financial crisis, stock markets around the world tumbled as nervous investors ran towards the exits. But not everyone ran. Legendary investor Warren Buffett, the “Oracle of Omaha”, began buying. Why? “A simple rule dictates my buying,” he explained in a New York Times op-ed. “Be fearful when others are greedy, and be greedy when others are fearful.”

In his comments, Buffett concisely summed up the twin forces that drive markets: greed, which motivates buying, and fear, which motivates selling. Knowing something about either sentiment can be very useful, regardless of whether you’re a passive market watcher or active investor. Greed, unfortunately, is difficult to measure. Fear, you might be surprised to learn, is not hard to measure at all.

Here in South Africa, the Johannesburg Stock Exchange’s South African Volatility Index (SAVI) measures fear on a daily basis. “For the layperson, it gives you a good idea of market sentiment,” explains Craig Pheiffer, general manager investments at Absa Investments. “It gives you an idea of where [markets] are in the fear spectrum.”

How does this indicator work?

Volatility is a measure of risk in financial markets. It can be calculated in one of two ways, from historical price data or from current option price data. This second method, which is used by the SAVI, results in an “implied volatility” measure. It represents a forecast of asset return uncertainty over a specified period of time.

To accomplish this, the SAVI measures the cost of buying options on the JSE Top 40, the 40 largest companies traded on the Johannesburg Stock Exchange. Launched in 2007, it is modelled on the Chicago Board of Options Exchange’s Volatility Index (VIX), a measure of the cost of options on the Standard & Poor’s 500 Index, a broad measure of stocks traded on the New York exchange.

Options are fixed-term contracts that give the purchaser the right to buy or sell assets at a predetermined price. They serve as a sort of insurance policy against unforeseen losses. Profits or losses are made from the difference between the option price and the market price of the stock at the expiration of the option contract.

The value of options is usually determined using the Black-Scholes pricing model, named after the two Nobel Prize-winning economists who invented it. The model takes into account a number of variables, including the length of the option contract, the stock price, interest rates and, most significantly, implied volatility. Each of these variables, with the exception of volatility, is known to traders at any given point in time.

Implied volatility represents the range of future prices of a given stock over the life of the option, three months in the case of the SAVI. The more uncertain investors are about the future, the more they are willing to pay for insurance.

“The mathematics is complex,” says Pheiffer, but by analysing options prices, calculating implied volatility is precisely what the SAVI does. Index values are calculated and reported at the end of each trading day. The higher the reported figure, the higher is the level of volatility or “fear” in the market.

How do I use this indicator?

“The SAVI is a measure of the overall risk level in the market,” explains Mark Reimer, a research analyst at Cadiz Securities. “If it is rising, then your exposure in the equity market is riskier.” So the first thing to look for is the direction of SAVI movement.

Although it’s not necessarily an exact correlation, says Riemer, the SAVI “tends to move in the opposite direction of the equity markets”. In other words, if stock prices are rising, SAVI levels tend to drop. When stock prices are falling, and fear is rising, the SAVI tends to creep up. “Market fear intensifies when the market is coming down,” explains Pheiffer, “and that comes through in the implied volatilities.”

But as Pheiffer points out, “Movement only means something if you know where it’s been before.” So the second thing to look for is where the SAVI is in relation to its long-term history, not just in relation to the day or week before. During the height of the global recession in 2008, for example, the SAVI spiked to historically high levels. Market rises in 2009 and 2010 restored investor confidence in stocks and the SAVI fell to near record lows. As concerns about Europe’s sovereign debt situation intensified in 2011, the SAVI again began to climb.

Pulling it altogether, the SAVI can be a useful indicator for those looking to gain an insight into overall market sentiment, whether the investor community is nervous about the future or more serene. From an investment perspective, the SAVI also has utility. As Pheiffer says, Watching the SAVI may provide the clues to when it’s time to get greedy again.”

When and where do I find this indicator?

The Johannesburg Stock Exchange (JSE) makes SAVI data available on a daily basis, but it’s quite a mission to find. For easier access to daily and historical figures, try the financial news and data provider Bloomberg (www.bloomberg.com).

Once you are on the Bloomberg website, type “SAVIT40:IND” into the search box located at the far left of the top menu bar, but don’t hit enter. After a few seconds, a blue box will appear with the words “get quote”. Now hit enter. The site will bring you to a page where you can examine historical SAVI data on a daily, weekly, monthly or yearly basis.