October 4, 2011 / 7:01 PM / 7 years ago

Analysis: Economic uncertainty could fan Wall Street volatility

CHICAGO (Reuters) - Volatility has stampeded through Wall Street since mid-summer and may stay through the winter if uncertainty about the European financial crisis and the global economy persists.

The Wall Street sign is seen in front of the New York Stock Exchange January 22, 2008. REUTERS/Chip East

Investor anxiety has intensified as the stock market has slumped for five consecutive months, with worries about Europe and the outlook for the United States fanning fears of more losses.

The fourth quarter began on Monday with the broad S&P 500 .SPX on the precipice of a bear market and investors lacking confidence in either European or U.S. policymakers being able to stem the disquiet surrounding the debt crisis.

Wall Street typically defines a bear market as a drop of 20 percent or more from a recent high.

Volatility is at its most persistently elevated since the financial crisis of 2008, as measured by the popular VIX, or CBOE Volatility Index .VIX. Barring a knock-out U.S. earnings period in the next month, it could remain high, and investors should brace for wild swings and more down days.

The VIX has been hovering in the 30s-to-mid-40s range since early August, peaking at 48 on August 8. The index essentially measures the cost of options to insure an equity portfolio, and its high level indicates how worried the investing community is about more declines in stocks.

“Given all of the headwinds, both in terms of European debt and continued fears of a possible global economic slowdown, it’s not surprising that the VIX has stayed elevated,” said Jeremy Wien, head of VIX trading at Chicago-based PEAK6 Investments.

The focal point has been Europe. Each day brings more uncertainty and anxiety as policymakers struggle to help Greece avoid a default. The subsequent impact on banks exposed to Greek debt on both sides of the Atlantic could fuel another credit crisis, and hurt growth.

“The European sovereign debt crisis is the No. 1 issue, but concerns about bank capital adequacy and global economic growth are two other significant factors,” said Bill Luby, a private investor in San Francisco who writes the VIX and More blog.

The VIX is a 30-day risk forecast of stock market volatility priced off S&P 500 options, typically rising when stocks fall and vice versa. There have been a number of big, short-lived spikes in volatility in the past, but this period has been notable for its length.

“The first time the European sovereign debt crisis put a big scare into the markets was May 2010. The VIX made it up to 48.20, but just one month later it was down more than 50 percent from that level,” Luby said.

On Tuesday, the VIX stood at 44.19, down 2.8 percent late in the session and below the August peak.

“We’ve been over 30 now since the first week in August and there seems to be no sign of that changing anytime soon,” said Jay Pestrichelli, co-founder and principal of Zega Financial LLC, an investment advisory firm specializing in option strategies.

This has boosted interest in exchange-traded funds that follow volatility. Volume in the Barclays iPath S&P 500 VIX Short-Term futures exchange-traded note VXX.P has climbed steadily in the last three years, recently peaking in August, when markets were roiled by the U.S. credit-rating downgrade.

Investors prefer less volatility. “Volatility erodes returns over time, despite the attractiveness of potential big upswings. Mathematically, volatility is Kryptonite for returns and reducing it is important,” Pestrichelli said.

It is rare for the VIX to stay over 30 for more than four months. The credit crisis of 2008 was one exception as the VIX stayed above 30 for nine months, he said.

Comparing the current spike to other historical VIX spikes, Luby said this one is notable for its duration above 40 and its tendency to keep returning to the 40s after short periods of decline.

“Without the 2008-09 financial crisis, the current VIX spike would probably qualify as the most impressive in the history of VIX data going back to 1990,” Luby said.

The VIX at 40 translates to expectations of swings of 2.5 percent in the S&P 500 one day out of three. Moves of that size “are quite rare and the VIX has a tendency of overstating the frequency of future large moves in the SPX,” said Luby.

VIX futures, however, indicate markets will remain unsettled in the months ahead.

If earnings are strong enough to ease worries over the U.S. economy, and if the euro zone crisis finally shows signs of being resolved, volatility should subside.

“But if the uncertainty in Europe remains through the fall, we should expect the VIX to stay between 30 and 50,” Pestrichelli said.

Reporting by Doris Frankel; editing by Jeffrey Benkoe

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