In spite of a couple of negative days on European and US markets the ASX200 just doesn't want to take a breather, even after rising over 25% from the lows of last June. While most fund managers, and even some brokers are concerned the market might be getting ahead of itself, there seem to be plenty of investors who are determined not to miss out - even though they would go near equities just six months ago.

AFM's Research Manager, Sean Webster has taken a look at the curious behavior of the VIX, the so called Fear Index, and it reverse correlation to the market: Taking a lead from an article published by Adam Hamilton in the US, the logic seems curious - that if the market has had a strong rally, investors lose their caution and become complacent. However the reality is often that the market is overbought, and therefore has a higher probability of a correction.

The cost of insurance however, as measured by the VIX, falls simply because there's less demand for protection. The reverse applies when the market has fallen sharply, and therefore stocks may offer better value: All of a sudden the cost of protection (the VIX) skyrockets as investors try to buy insurance after the event.

Sean's article and associated charts can be seen here. It's a moot point of course whether the VIX leads the market, or the market leads the VIX. What it does show however is that potential risk is always around the corner and investors ignore risk at their peril.

Meanwhile there's plenty of media coverage about incidents (some actual, some alleged) of insider trading, both in Australia and overseas. Last Saturday's AFR contained an interview with Belinda Gibson from ASIC and covered the attempt by an offshore fund manager trying to gain early access to a local broker's research and information. Aspects of trading in Heinz in the US ahead of Warren Buffett's recent proposed purchase are being investigated, and a major US hedge fund is also in the SEC's sights.

However as we argue in this article, institutional investors, including hedge funds get access to information not generally available to ordinary investors, whether by their added research capacity, by investor briefings directly from the company itself, or through broker presentations. There may be no insider trading involved, but there is certainly no level playing field either.

This week's now for something completely different contains not one but two completely different clips. We hope you share our appreciation of The Two Ronnies, who still make me laugh even though the material is now well dated. Our second clip is far from amusing but well worth watching: Last Monday's "Australian Story" on the EasyBeats' lead singer Stevie Wright on ABC TV was a chilling reminder of the dangers of drugs. It's a long clip, so if you're short of time watch it from about 4 minutes onwards. The program is re-broadcast on the ABC at 12:30pm Saturday afternoon. Record it and play it to your children.

Otherwise enjoy the week-end.

Regards,

Chris.

Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril.

A recent article (January 2013) by Adam Hamilton of Zeal LLC examines the role of the VIX as a leading indicator for the S&P 500. In the current bullish climate for equities and very low levels of volatility this might be a timely reminder that risk is often present when least expected.

We have reproduced the chart from the Zeal article and also added a chart of the ASX and a local volatility index. Meanwhile the full Zeal article can be found in this link.

Hamilton points out that the US market has had a strong rally with stocks at their best levels is 5 years and the S&P 500 (SPX) recording 8 new cyclical highs in 13 days. However the gains have been marked by very high levels of complacency by investors, and as contrarians would be aware, most investors become bullish only after major rallies.

The issue for investors is how best to measure the bullishness or complacency of the market. Over time a number of indicators have been developed with the best based on the option trading concept of implied volatility. Given that traders buy options to bet on future price moves investors can analyse how fast they expect markets to move in the near term. The most well known indicator here is the VIX. It is commonly known "the fear gauge" i.e., the higher the implied volatility the more fear is being reflected in the VIX and vice versa.

Hamilton's article notes that the author prefers to use VXO index as opposed to the VIX and details the rationale for this. In summary the VXO looks at near-term at the money S&P 100 options, as opposed to the VIX which amongst other differences uses the S&P 500.

Read the entire article from Sean Webster here.

ATTACHED FILESIs low volatility a sign of low risk, or investor complacency? (pdf format)