This week’s COW takes a look at the Volatility Index (“VIX”), defined by the CBOE as the measure of short-term stock market volatility conveyed by S&P 500 option prices. It is also known as the “markets fear index”, as VIX tends to rise when markets are falling. Although the VIX has been extremely volatile since the Financial Crisis of 2008, we chronicle the events of the last two months in an effort to further illustrate the dramatic equity market movements of summer 2011.

Looking at the chart, we first notice the overall inverse relationship between the S&P 500 index (red line) and VIX (gray line); when one index is falling, the other is rising – not surprising, since we would expect market fear (as measured by the VIX) to increase when the equity market (S&P 500) is falling. Second, the month of July was relatively quiet, as neither index showed much movement over the course of the month. However, as August arrived, several events triggered substantial movements in the two indices. We focus on three of the most notable:

• On Monday, August 8^th, S&P downgraded the United States’ credit rating from AAA to AA+; VIX saw a 50% intraday gain from 32 to 48.

• On Thursday, August 18^th, VIX closed 35% higher than the previous day in the wake of more rumored problems for European banks, settling at 42.67 by end of day.

• Finally, August 24^th featured another large movement in the VIX index when it was announced that the CEO of Apple, Steve Jobs, was resigning due to health concerns. VIX quickly subsided though as markets expressed confidence in his successor to maintain Apple’s impressive run.

For the sake of comparison, the five-year average of the VIX index is 24.32; thus these elevated figures in August certainly reflect a higher than normal volatility, which has indeed played out in the equity markets. Although the figures do not approach the all-time high of 96.4 when markets were collapsing in October of 2008, the elevated levels have made investors stand up and take notice. Unfortunately, the VIX will likely continue to be volatile, which is a direct reflection of expected choppiness in the equity markets.

This week’s chart looks at the amount of excess reserves banks are holding at the Federal Reserve (orange line) along with the corresponding changes to the Federal Reserve’s balance sheet (black line). As of the end of July 2011, banks are holding over $1.6 trillion in excess reserves, which is notably higher than what historical averages would suggest. This has led some market commentators to worry about inflation escalating as banks begin to lend out those assets (note that overall loans and leases issued by commercial banks, as represented by the red line, have fallen since the Financial Crisis of 2008 – 2009).

In the United States, all depository institutions (commercial banks, savings and loans, credit unions, etc.) are required by the Fed to satisfy a reserve requirement (or liquidity ratio): each bank must retain a certain amount of cash that cannot be used for loans to business or consumers. Any reserves held above the required amount are considered “excess reserves”.

Historically, institutions have minimized their excess reserves because it is generally more profitable to issue loans than to hold the cash (the banks can earn higher amounts of interest via loans). When money is lent by banks, it can have what is called a multiplier effect on money supply: because banks only have to hold a small percentage of assets to meet the reserve requirement, they are able to increase the money supply by lending. For instance, with a 10% reserve requirement, $100 could theoretically be turned into $1,000 through the multiplier effect.

As a result of this theory, many market commentators have expressed concern over the current large level of excess reserves held by banks. Based on this macroeconomic theory, even a relatively small decline in excess reserves of $100 billion could theoretically increase the money supply by $1 trillion (assuming a reserve requirement of 10%).

The Fed is confident that inflation is not a near term threat to the economy, and when (if) inflation does become a concern, it has the tools to control the growth of price levels. A large output gap in the U.S. economy, high levels of unemployment, and slow wage growth are the most commonly cited reasons for the expected low levels of future inflation. The Fed also has a few tools to help combat inflation from excess reserves, including selling large amounts of securities from its balance sheet (either outright sales or using reverse repurchase agreements) or increasing the interest rate it pays on excess reserves to incent banks to continue to hold excess reserves. The ability to pay interest on excess reserves is a new tool for the Fed and in its view alters the theory behind the multiplier effect.

The fact remains that the U.S. is in uncharted monetary policy territory, with little historical precedent to rely on. As Fed Vice Chairman Donald Kohn said, “the calibration of our exit from these policies is complicated by a paucity of evidence on how unconventional policies work. We will need to be flexible and adjust as we gain experience”.

This week’s chart examines the frequency and magnitude of market corrections in the U.S. equity market, as measured by the S&P 500 Index. A market correction is defined as a decrease of 10% or more within one calendar year. Using data back to 1950, we found that every year featured at least one market drawdown, and over half of those years (35 of the 62 years, approximately 56%) were true market corrections. What is even more interesting is how large some of these corrections were, with 11 of those years seeing intra-year declines of over 20%. So while the steep drop over the last week has contributed to an 18% decline in the S&P 500 Index (through Monday’s close), perhaps investors can find some reassurance knowing that more severe market corrections have occurred in the past.