Fear Goes Viral on Wall Street
Business + Economy

Fear Goes Viral on Wall Street

So much for the stock market being too complacent. The Dow Jones Industrial Average tumbled more than 450 points by midday Wednesday before erasing most of those losses in seesaw action that might have left traders with whiplash. Stocks plunged more than 2 percent at the open, recouped some losses and then dropped to fresh lows that erased the S&P 500 index’s gains for the year and left the Dow off by more than 4 percent for 2014. By late afternoon, the losses had been pared back to just over 1 percent for the Dow and 0.81 percent for the S&P 500.

In case it wasn’t clear before: Fear and volatility are back.

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Reinforcing that point, the CBOE Volatility Index (the VIX) briefly spiked more than 36 percent to a level above 31, the highest it’s been since late 2011, when the Eurozone debt crisis gripped investor attention. It wasn’t all that long ago that the market’s so-called fear gauge was hovering closer to 10, well below its long-term average of around 20. But renewed fears about the European and Chinese economies, some surprising signs of weakness in the U.S., falling oil prices and even headlines about Ebola have shaken investors’ out of their calm.

“I suppose we have to factor into our investment strategy this new ‘Fear Factor,’” Ed Yardeni of Yardeni Research wrote to clients this morning about the Ebola concerns. “The stock market is now driven by emotion rather than fundamentals. The former rapidly switches from greed to fear on Ebola news. At the same time, the latter remain supportive in the US, but less so overseas given the slowdown in global economic growth.”

What Yardeni calls emotion others refer to as investor psychology, noting that fear can lead to more fear and selling begets more selling. “In research done following the 1987 stock market crash, Robert Shiller asked investors what factors they cited for the market crash; their response was the sharp declines the week before the crash,” David Blitzer, chairman of the index committee at S&P Dow Jones Indices, wrote this week. “Crowd psychology plays a part.”

In that environment, Ebola is far from the most pressing fear, or the one that’s most relevant to investors. “Over recent weeks the outlook for many asset classes has become more uncertain as the toxic combination of multiple geopolitical risks mix with the latest downgrades to the global growth outlook,” Credit Suisse said in inviting clients to dial into a conference call on The Return of Volatility. “Indeed, following the dramatic moves in market prices over recent days, market participants are now openly questioning whether the outlook in many markets has fundamentally changed.”

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If it has changed, investors using an outdated playbook could get burned. As Tim Edwards, director of index investment strategy at S&P Dow Jones Indices, noted in a blog post, the VIX has collapsed every time recently that it has jumped above 20. “Yet volatility levels are not guaranteed to fall,” Edwards wrote. “If the U.S. Federal Reserve’s largess was indeed the primary cause of the suppressed levels of volatility seen in the first three quarters of this year, the seat-belts are off.” Edwards notes that VIX short-sellers risk getting caught in a squeeze. “Hypothetically, such a short squeeze would trigger large purchases in volatility futures just as it is already shooting up,” he suggests. “A jump from 25 to 35 in such circumstances is not entirely unfeasible.”

^VIX Chart

^VIX data by YCharts

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Even so, the latest spike is still much milder than those of past scares; the VIX reached an all-time high above 80 in November 2008, after Lehman Brothers collapsed into bankruptcy. So while fear is on the rise and the S&P 500 is nearing correction territory (10 percent off its high), let’s keep the current jitters in broader perspective.

As Ashvin Chhabra, the CIO at Merrill Lynch Wealth Management, pointed out in a recent note, the S&P 500 has soared more than 200 percent since 2009, and this is just the fourth pullback of 5 percent or more in two years. Those kinds of pullbacks more typically happen a few times a year.

The smartest strategy, then, may still be to keep in mind Warren Buffett’s well-known advice — words that are easy to say and much harder to act on intelligently: “'Be fearful when others are greedy and greedy when others are fearful.”

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This article was updated at 4:15 p.m. ET on Wednesday, October 15.