Turning panic into opportunity

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When all around are panicking, smart investors should be cooly asking whether it is time to buy. What signals should they be looking for?

One of the first measures is the VIX, or volatility index, which measures the variability of the American stockmarket. It is trading around the 30 level, or near its peak in March when Bear Stearns had to be rescued.

The theory is that, when volatility is high, markets are usually falling. That is because there is rarely such a thing as a “forced buyer” of shares. But there can be forced sellers, when investors need to dump their holdings to meet margin calls or repay debts. Faced with such selling, marketmakers adjust their prices sharply and that is what creates spikes in the VIX.

The VIX is well above its post-1990 average, according to the Chicago Board Options Exchange, which trades futures and options on the index. But it has yet to reach the heights seen in 2002, or when Long-Term Capital Management, a hedge fund, was being rescued in 1998. Both incidents, which pushed the VIX above 40, proved to be good moments to buy shares on a 12-month view.

A second signal may seem a bit parochial to international readers. It is when the dividend yield on the FTSE All-Share (the broad-based British index) is higher than the yield on ten-year gilts, or government bonds. In other words, investors get paid more to hold equities (with all their growth prospects) than stodgy government bonds. The market passed this threshold on March 12th 2003 for the first time since the late 1950s. To the day, it marked the end of the 2000-2003 global bear market. At the time some commentators said this signal did not matter, since dividends would probably be cut. In fact, the dividend income on the index has almost doubled in the five years since.