The Sunday NYT reveals a common misunderstanding about volatility:
"Feeling relaxed? Evidently, many investors are. An important gauge of stock market volatility has reached its lowest level in about eight years, and that is making some analysts anxious.
The VIX index, a measure of the amount of volatility that options traders expect the Standard & Poor’s 500-stock index to experience in the near future, recently fell to its lowest level since 1996, dipping below 12. What makes that cause for concern is that when traders anticipate calm, they almost invariably get something else.
Market volatility is highly correlated with future price movements. As the VIX, known more formally as the Chicago Board Options Exchange S.& P. 500 Volatility Index, moves to extremely low levels, stocks tend to head in the same direction fairly soon.
By contrast, high VIX readings tend to occur during market lows – events that typically mark a crescendo of selling and the birth of an advance. The VIX exceeded 40 close to the time of lows in the fall of 1998, the fall of 2002 and just after the Sept. 11, 2001, attacks."
This is a bit of an oversimplification; While a low VIX reflects complacency — never a good sign for the Bulls — it is not a surefire way to call a top. What number is too low? 20? 15? 9? As the chart below reveals, the VIX can exist comfortably in the low teens or even single digits while the market still rallies. In the early 90s, the VIX stayed in the single digits.
I use the VIX as a secondary indicator to confirm other signs of excessive Bullishness. Recall back in October 2003, we noted the possibility of a short term correction. But it was based not on a low absolute VIX, but rather on a VIX that had dropped at least 10 points (recently) to below 18. This is a significant difference. (Read the full piece "VIX Foretells Short Term Correction," for more data and details).
In January 2004, I noted a major top was forming in part to the VIX — but it was merely one of three factors: The low VIX, plus a "stunningly low Bearish sentiment, and a Put/Call ratio, which had dropped to thew lowest levels since 1997.
In October ’03, the VIX dipped below 17 — which led to a short term Bearish call; In October ’04, the VIX was at 13, and that led to Bullishness! The point being that its relative, raw numbers provide minimal data, and additional confirming signals are key to have any degree of confidence.
Note that the Times quotes a strategist who also looks at the spread between Treasury bond yields and yields on junk bonds and other low-quality debt. Lately, yield spreads have been at their lowest levels in 14 years. I haven’t backtested a Treasury/Junk spread versus VIX, but it may be a worthwhile exercise.
VXO Weekly Chart, 10 years
click for larger graphic
chart courtesy of BigCharts.com
Note that VIX peaks are far more conclusive than lows; Its much easier to spot
a bottom — a selling capitulation — than a top; You can usually tell
when people have puked out all their holdings; Its much more difficult
to tell when they run out of purchasing power/interest.
When Traders Get Comfy, Watch Out
Conrad de Aenlle
NYT, December 26, 2004
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