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July 2010

On July 1 the €442 billion bank-lending program of the European Central Bank is ending. The Central Bank introduced the lending program 12 months ago to ensure adequate liquidity within the European banking system and to encourage private-sector lending. A year ago the ECB was eager to set an early end to these emergency measures, but the crisis of confidence in some weak debtors like Greece and other countries of the Union has forced a change of mind. Now the lending-program will have to be extended on similar terms. These facilities are a lifeline to banks in Greece, Spain, Portugal and Ireland, until confidence returns and they gain access again to interbank lending. The turbulence around financially weak European debtors and the speculation against the Euro have vividly demonstrated how fragile the world financial system remains one year after the crash. It takes very little and general mistrust spreads, money is being horded and the flow of credit dries up. That is what led to depression during the thirties.

This leads us to the overwhelming influence of fear, which has always been present in markets. The best-known gauge of investor panic is the Chicago Board Options Exchange Volatility Index or VIX , which is also called the fear index. It reflects premiums on options on the S&P500 index. A high reading occurs in times of stress. Its long-term average is about 20 , last May it surged above 30. During Lehman’s collapse it hit 60. The moments of greatest panic occurred during the financial crisis in Russia in 1998, the panic engendered by the collapse of the Long-Term Capital Management Fund a few months later, the dotcom crash in 2000/02 and the September 11th terrorist attack in 2001. Studying theses indexes and analysing the causes of these outbursts can help us to gain perspective in a situation and to free ourselves from emotion. We learn that in every crisis, without exemption, the index will rise, sometimes spectacularly, but once the crisis has passed the zenith it will head back to the average. The lesson is not to sell during a spike of this fear index, rather to sit tight or to buy. The fear index, properly interpreted, is another plus at our disposal to succeed in a difficult stock market.