From the pen of Karin Iten…

Dear Investment Academy Reader,

Is the market on the verge of relapse? One man who’s been a step ahead since the credit crunch began thinks so – Morgan Stanley strategist Teun Draaisma. Having warned his clients of the downturn in 2007, at the end of 2008 he turned bullish, calling for a “full house buy”.

Now he sees another turn looming.

“We think the market peak is near, and expect 2010 to show a volatile whipsaw pattern in equities… When the next earnings recession hits, perhaps in 2012, we expect equities to complete the bear market that started in 2000.”

Sound ominous, doesn’t it? But we’ve found a great way for you to judge when the turn will come – and today, investment strategist Theo Casey will tell you all about it.

Investors could be facing another bout of “death by correlation”. Two years ago, even investors with classically diversified portfolios lost an average of 33.3%. Diversification failed us all.

So, to survive the next dip, it’s worth considering all options.

Enter the VIX.

While the rest of the market (bar bonds) slumped, it quietly returned 72.6%.

What is the VIX?

The VIX is a gauge of fear in the stock market. In other words, it reflects how nervous investors are collectively and what they believe might happen next. It was created by Professor Robert Whaley to measure the premiums paid by investors who buy 30-day option contracts tied to the price of stocks traded on the S&P 500. These options allow investors to buy or sell stocks at a future date at a set price.

The mechanics can get technical quite quickly. But in principle these options boil down to insurance policies for investors worried about a big market move.

For example, a “put” option allows an investor to dump stocks at a pre-determined price should the market plummet. The price of that insurance varies – the option “premium” goes up or down – and that’s what the VIX tries to capture for whole groups of stocks. As Mr Market gets more nervous, option premiums rise and so does the VIX.

“It’s analogous to buying fire insurance,” says Whaley. “If there’s reason to believe an arsonist is in your neighbourhood, you’re going to be willing to pay more for insurance.” So, trading alongside the US stock market from 2.30pm to 9pm London time, the VIX provides a useful, timely snapshot of sentiment. And plenty of professional investors have cottoned on to this fact.

Does it work?

The VIX has a pretty good track record. It spiked in 1998 when infamous hedge fund Long-Term Capital Management collapsed. It spiked again after the September 11th terrorist attacks. And at its peak – 80.86 on 20 November 2008 – the fear index was up 249% for that year-to-date.

Since then, the VIX has fallen a long way. It’s currently at just 17.50, a good way below the 30 level that many VIX watchers reckon signals trouble.

But the next time we have a panic, and a capitulation in share values, history has
shown that the VIX could double, triple, or more.

Keep your eye on this indicator. If things go south, it’ll be one of the first to tell you.

Here’s to your financial freedom,

Theo Casey
for the Investment Academy