The new language of a new world in the old sharemarket

The fear index

This is one that you hear a lot. "Fear is at all time highs" seems to be the slogan. You're probably wondering how on earth you measure a subjective thing such as fear.

The fear index doesn't really measure fear. It measures volatility. The fear index is really the volatility index or the VIX index as it's known by traders. It's used by option traders to measure the implied volatility of the S&P 500 index. It measures the market's expectation of the volatility of the S&P 500 over the next 30 days.

A high value means that options cost more so traders have to pay more to insure their portfolios. Recently, we saw the VIX index reach an all time record at 90 points. A lower number means that it costs less to protect your portfolio and less volatility in the market.

So if you see the fear index at an all time high, it's bad for the sharemarket because it means that the market is probably seeing some big falls. At the moment the fear index is at 60 point which is still panic territory.

A more normal rate would be 10-30 but what do you call normal in this market?

Relief rally

A relief rally or bear market rally is the market moving upwards only to be followed by another move down. It's often called a suckers rally because it convinces some that the market has turned and when they've bought into the market, the market once again falls in line with the bear market trend in place at the moment.

It's only normal that even in a bear market, you get bursts of optimism. Make sure that you aren't sucked in to a bear market rally because the market will correct and move back down.

So how do you know if the market has turned? There are many measures but I prefer to think of the sharemarket as a leading indicator of the economy and I think we will see the sharemarket turn 3-6 months before the economy does.

Libor

Looking back, this market downturn will be called the credit crisis. I'll be able to say that I lived through the credit crisis. The credit crisis has come with it's own language. 2 years ago, few people would have heard of the Libor or the interbank lending rates.

The Libor is the London Interbank Offered Rate. Just like in the sharemarket we use a benchmark like the all ordinaries index or the S&P ASX 200 index to measure the performance of the Australian sharemarket, the benchmark for bank rates is the Libor.

It is usually roughly comparable with the US Fed Funds rate. But at the moment US interest rates are at 1%, the Libor is at more than 3.5% and therein lies the problem. No matter if central banks cut rates, the banks aren't passing them on because the rate that banks lend to each other isn't a reflection of official interest rates. When we still the Libor get closer to the US interest rate, that's when we know that the problems from the credit crisis may be starting to dissipate.

So for real market rally, you don't want a relief rally or a bear market rally, you would want to see the fear index at between 10-30 instead of 90 and you would want to see the Libor rate closer to 1% than 4%.

Happy investing!