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Stocks highlighted include Bristol-Myers Squibb (BMY), Kimberly Clark (KMB) and Healthspring (HS). Also highlighted is the S&P 500 (SPX). What The VIX Is Telling Us The markets continue to experience unusual volatility. This can be seen in the CBOE Volatility Index (VIX), which set record highs yesterday. The VIX calculates the expected stock market volatility for the next 30 days. The indicator accomplishes this by using a weighted average of implied volatility from S&P 500 index options contracts. Specifically, the VIX looks at options for the 2 months closest to expiration, which is currently November and December. (October contracts expire today and are no longer factored into the indicator.) Options prices are based on a combination of risk-free interest rates, expected changes in the price of the underlying asset and time to expiration. The more the price of a stock (or index) is expected to change in the near-term, the higher the amount of volatility an option contract is going to price in. In other words, the more volatile a stock price is, the more its options contracts are going to cost. Volatility increases the cost of an option contract, because there is a greater likelihood that the contract will expire "in the money". At expiration, a trader can exercise his right to buy, or in the case of a put - sell, the underlying asset at a fixed price. Alternatively, he can let the option contract expire worthless. Obviously, if a trader can buy a stock for less than its current price or sell it for more than its current price, he will do so. The more one thinks an option is going to be valuable at expiration, the more he is going to pay for the contract. In the case of the VIX, traders are fearful that the S&P 500 is going to have more large swings over the next two months. Therefore, they are paying more for options contracts. Simply put, they expect to exercise their options contracts at expiration. In a falling market, this is bearish, because traders are essentially betting on a further decline. Is The VIX Calling For A Rally? The VIX is a contrarian indicator, however. A study by Credit Suisse found that, after adjusting for market drift, high VIX levels correctly predicted a 5-month rally 63% of the time. Given that the indicator is at record levels, it is essentially calling for one heck of a forthcoming rally. This is partially why some market observers believe that now is a buying opportunity for investors. Before anyone goes out and bets the farm, however, I should state that there continues to be real economic problems. Though the freeze on credit is starting to thaw, short-term credit remains very difficult to secure. More jobs will be shed and an unemployment rate in the high single digits is within the realm of possibilities. Consumers are tightening their budgets. A higher number of home foreclosures and credit defaults will occur. Demand for exports will be weaker in the months ahead. Not to mention, the trend in earnings estimates for 2009 is negative. Implications for Our Portfolios We had refrained from adding new stocks to the Focus List and the Growth & Income portfolio because of the prevailing market conditions. While I cannot say with certainty that a short-term bottom has been established, I do believe the short-term risk of buying stocks has diminished. Therefore, we have started the process of rebuilding our portfolios. Our strategy is to start with less economically sensitive sectors, with a preference towards large-cap companies. (Though, in general, we are market-cap neutral.) As the portfolios increase in size and the market stabilizes, we will look at companies with a higher risk profile. This strategy was evident in the most recent additions to the Focus List: Bristol-Myers Squibb (BMY), Kimberly Clark (KMB) and Healthspring (HS). BMY and KMB were selected both for their size and their respective industries, pharmaceutical and consumer staples. HS was chosen because it receives its revenues from Medicare. Ideally, I would like to add a 2-3 stocks each week going forward to the portfolios. Spreading out the additions helps to reduce the risk that our timing is wrong. The actual number of additions per week will vary. The Markets My gut says a market bottom was set last Friday. Prevailing trends, however, paint an uncertain outlook, however. Nonetheless, we did see some gains this week, which is a big positive. The gains, however, came with a very large amount of volatility. When a market rebound does occur, my best guess is that we will then settle into a new trading range. Going back to the volatility, I want to show you a 10-year chart of the VIX. We have never seen the index at this high a level and, after things calm down, it will be a long time before we see it again. Keep Looking At Stocks I will reiterate what I've been saying for the past several weeks - the economy will recover and stocks will find new highs. The economy goes through cycles, with recessions typically being considerably shorter than periods of expansion. The best thing you can do is keep researching stocks. This is what successful investors do. We'll help get you through it by finding fundamentally sound stocks while giving you the tools necessary to do your own research.
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Charles Rotblut is the Vice President of Web Content for Zacks Investment Research and the Senior Market Analyst for Zacks.com. He oversees the editorial staff, manages the market-beating Focus List, Timely Buys and Top 10 portfolios, and plays an instrumental role in the development of new products. For more information, visit www.zacks.com.
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