On Monday, the VIX Index broke 40 -- a very rare occurrence. The VIX is a short-term indicator of stock market volatility, but I'd suggest that at extreme values, it becomes a good long-term indicator of stock market valuation. While Monday's milestone implies that the market remains expensive at current prices, there are also clear opportunities to buy the shares of first-rate businesses on the cheap.

Extraordinary events, unusual markets
The VIX is "Wall Street's fear index." It tracks the market's expectation of how volatile stocks will be in the near term. The CBOE exchange calculates VIX index values based on the prices investors are willing to pay for options that provide downside protection for the S&P 500.

Since its inception in 1990, there have been only five periods during which the VIX has traded above 40. In each case, the initial spike was precipitated by an extraordinary event - even a couple of Black Swans - occurring in an unusual market context. The following table documents these dates, along with the S&P 500's annualized return from each date through yesterday:

Date

Precipitating Event

Market Context

S&P 500 incl. dividends, Annualized return through Wednesday

Aug. 8, 2010 U.S. downgraded to AA Sovereign debt crisis --
May 6, 2010 Flash crash Sovereign debt crisis 1.5%
Sep. 18, 2008 Lehman Brothers bankruptcy Credit crisis (0.3%)
Jul. 22, 2002 WorldCom bankruptcy Post Tech bubble bear market 5.6%
Sep. 17, 2001 9/11 Attacks Post Tech bubble bear market 2.7%
Aug. 31, 1998 Russia defaults on its debt Asian financial crisis 3%

Source: Yahoo! Finance, Standard & Poor's Indexes.

Only the returns associated with the three earliest dates correspond to periods long enough to be meaningful. The returns achieved aren't disastrous, but neither are they enough to compensate investors for owning stocks - they're well below stocks' long-term historical return.

The market isn't cheap enough to buy
That suggests that when the VIX breaks 40, the broad market may decline on the day, but it isn't cheap enough to buy. Our sample is very small, but there is economic logic behind the phenomenon. The Shiller P/E, which uses average 10-year real earnings instead of single-year earnings estimates, confirms that stocks were expensive on each of those days:

Time Frame

S&P 500, Shiller P/E Multiple

Long-term historical average 16.4
Present: Aug. 10 19.3
May 6, 2010 20.7
Sep. 18, 2008 19.1
Jul. 22, 2002 24.3
Sep. 17, 2001 24.6
Aug. 31, 1998 30.7

Source: Robert Shiller's website.

Those results fit the notion that you shouldn't buy during the initial surge in volatility, because it signals that a legitimate correction has yet to occur. By legitimate correction, I'm referring to a market that returns to (and usually overshoots) its fair value.

The market isn't cheap
In sum, I don't believe the broad market is cheap enough to buy ... yet. Investors should refrain from putting money into index funds like the SPDR S&P 500 Index ETF (NYS: SPY) , unless they do so as part of an automatic monthly program. If the S&P 500 were to drop a further 10%-15%, it would reach levels at which investors can expect to earn returns roughly equal to the historical average (6.5%, after inflation.) Note that this holds true only over periods adequate for equity investing -- 10 years, at a minimum. A 6.5% real return may sound like peanuts, but it's nothing to scoff at.

Prefer individual stocks to the broad market
The good news is that individual stocks aren't uniformly expensive. In fact, the following names sport very attractive valuations:

  • The consumer-staples sector is a smart, defensive choice in a very difficult economy. Two of the leading companies in that sector, Colgate-Palmolive (NYS: CL) and Procter & Gamble (NYS: PG) , are attractively priced relative to their earnings power.
  • The health-care sector will also hold up well if the economy deteriorates further. Johnson & Johnson (NYS: JNJ) and GlaxoSmithKline (NYS: GSK) are world-class franchises, but at less than 12 and 11 times forward earnings, respectively, they're priced as if they were mediocre businesses. Johnson & Johnson pays a dividend yield of 3.8%; at GlaxoSmithKline, it's 5.3%!
  • If you're willing to take a bit more risk, Wells Fargo (NYS: WFC) is the highest-quality national megabank in the country, and you can buy its shares below book value. At these prices, you're paying a small premium over Berkshire Hathaway's cost basis on its position at the end of June. Berkshire is Wells Fargo's largest shareholder.

As you take advantage of this opportunity to look at specific stocks, keep in mind that there is no need to use up all your powder with a single shot. The market may yet offer up even better bargains.

Add all of these companies to My Watchlist.

At the time this article was published Motley Fool Stock Advisor co-advisors Tom and David Gardner invite you to "Watch This Before the Market Crashes."Fool contributor Alex Dumortier holds no position in any company mentioned. Click here to see his holdings and a short bio. You can follow him on Twitter. The Motley Fool owns shares of Johnson & Johnson and GlaxoSmithKline. The Fool owns shares of and has created a ratio put spread position on Wells Fargo. Motley Fool newsletter services have recommended buying shares of Procter & Gamble, Johnson & Johnson, and GlaxoSmithKline. Motley Fool newsletter services have recommended creating a diagonal call position in Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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