Schaeffer's Trading Floor Blog

Breaking: A Weak VIX Isn't Bullish

The VIX drop marked the fastest flip from overbought to oversold on record

by 1/9/2013 8:25 AM
Stocks quoted in this article:

So, it turns out that not only was that recent CBOE Market Volatility Index (VIX) drop the fastest flip from overbought to oversold on record, it was also the fastest drop by various other measures. As per The Wall Street Journal's MarketBeat column, the 37% hit was the biggest five-day drop since 1990.

And, according to the same column, it doesn't bode well going forward:

In the nine previous instances in which the VIX fell by 30% or more over a five-day span, stocks have lagged their customary returns, Bespoke Investment Group says.

As the chart shows, the S&P 500 has averaged a 1.5% decline over the next week, Bespoke says. The index also averages a drop in the ensuing month and three-month time horizons.

Over the next six months, the S&P 500 has averaged a 3% gain, below a 3.9% average return for all six-month periods since 1990.

"The results are not attractive," says Paul Hickey, co-founder at Bespoke.

My point would be… um, yes, this is 100% expected. Pre-2008, the entire world basically acknowledged that VIX, or any measure of volatility, was a contra tell. It's a measure of Fear, and the greater the Fear, the greater the likelihood that it's misplaced. Low and/or oversold VIX is an indication of complacency. It's not as good a market timer as overbought VIX, but it's certainly not bullish.

In 2008, the VIX kept rising and the market kept tumbling, and the conventional wisdom changed. Now, it's become some sort of smart-money gauge.

Except it's not. It's part a hedge against an uncertain future, but mostly a reaction to what has just transpired.

When VIX drops that far that fast, there's really only two possible explanations: the VIX itself was originally bid up ahead of an expected news event, and now that event has passed; or, the market itself rallied sharply.

This recent VIX implosion fits primarily into Door No. 1. We clearly got bid up ahead of the Looming Fiscal Cliff. Once it no longer Loomed, the need for protection eased. The market, of course, rallied, but not enough to fully explain the drop.

But either way, it doesn't suggest a great time to load up on stocks. The news is now out and the market has reacted. Whatever drives the market next simply hasn't hit the screens yet. The most likely action is we meander and digest and go from there.

Disclaimer: The views represented on this blog are those of the individual author's only, and do not necessarily represent the views of Schaeffer's Investment Research.

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