How Bad Will Sequestration Be? Use This Ticker To Tell

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In December we discussed a great way to take cover from the Fiscal Cliff. But the Cliff turned out to be a two-step bunny slope, and the first hill wasn't so bad for Wall Street. We're about midway towards the second hill and it's a great time to review what we've learned so far. First off, the stock market remains hard to predict in the short term, but we already knew that. Second, it's tough to cut through the media noise and determine how serious any given "crisis" really is.

Now, Mr. Market won't get any easier to predict in the short term, but what if I told you there was a way you could measure investor fear? Troops, let me introduce a great addition to your utility belt: the CBOE Volatility Index (VOLATILITYINDICES: ^VIX), sometimes referred to as the Fear Index.

Straight from the horse's mouth (The Chicago Board Options Exchange), the VIX "is based on real-time option prices, which reflect investors' consensus view of future expected stock market volatility." If you want to learn more about stock options, I highly recommend The Motley Fool Options service. For now, just understand that the VIX is based on actual contracts that investors have paid real money for. These contracts give them the option to buy or to sell S&P 500 (SNPINDEX: ^GSPC) stocks during the next 30 days. So they haven't actually bought the stocks, they have a contract which allows them to do so at a given price. Confusing, isn't it? You're not the only one who thinks so. Bottom line, if you are unfamiliar with options then I recommend you stay away from them until you know more. But that doesn't mean we can't use the VIX to help us make "normal" investment decisions. Let's look at the VIX another way:

<img src="/media/images/user_13562/vix_large.png" />

The VIX got above 40 only three times in the last five years. It's pretty obvious what the 2008 spike was: the financial meltdown. But did you remember the other two times? In 2010 congress passed the Dodd Frank Act, which set new regulations on banks, companies, and investing. It's safe to say investors were scared about that. In 2011 the debt limit fight led to an agreement to cut $900 billion with a further $2.4 trillion in cuts and taxes to come. That double spike? The agreement was so messy that the US had it's credit rating downgraded for the first time ever.

Let's say you are contentedly following an investing plan similar to this previous post that painlessly takes you from E-1 to millionaire.  What would have happened to your investment in the S&P 500 when the VIX spiked? By "your investment in the S&P 500," I'm talking about your Thrift Savings Plan C Fund. With annual fees of only .025%, the C fund is the best S&P 500 index fund that service members can buy. The C Fund is part of the low cost TSP benefit to service members and federal workers, and is managed by Blackrock Institutional Trust Company National Associates, a privately owned affiliate of Blackrock (NYSE: BLK).

If you aren't using the TSP, Vanguard's S&P 500 ETF (NYSEMKT: VOO) is a good way to go too. Vanguard Group has an excellent management reputation. VOO's annual fees are slightly higher than the C Fund at only .05%. Plus, unlike the TSP, Vanguard's S&P 500 ETF is directly trackable by internet stock services. Well, it's trackable back to September 2010 which is when it was created. In order to look back further, say to the financial meltdown, we'll look at the S&P 500 index directly. 

<img src="/media/images/user_13562/vix-vs-sp-500_large.png" />

You can see that when the VIX is low, it's smooth sailing for the S&P 500, while spikes mean rough waters ahead. Now here's what the VIX isn't: it doesn't predict where the market is going to go in the next 30 days. Although the VIX spike preceded the meltdown, it came after the debt limit agreement and downgrade in credit. Trying to sell on a spike and buy on a comedown will most likely help your broker's commissions more than anything. A lifetime of sound investing, not just trading tickers, will smooth out the bumps along the way and allow you to catch that 6% wind to the land of the milionaires. What the VIX can help you do is cut through the media noise and understand how serious Wall Street thinks a given crisis is. It's another great piece of evidence when weighing your long term investing decisions. 

Now, how did the VIX react to part one of the so-called fiscal cliff? See that little baby spike at the end of 2012? Practically a non-event. But add VIX to your watch list and keep an eye on it going towards the end of February and the beginning of March. Congress has to address another debt limit, spending cuts, and sequestration all at the same time. The VIX will indicate how serious Wall Street thinks this new crisis is (or isn't!).

Fool up Troops, there's wealth to be built!

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