What a Massive VIX Drop Means for Stocks

The results of the French presidential election over the weekend eased widespread fears of a future "Frexit," sparking a global relief rally for stocks. What's more, as traders once again whet their collective appetite for riskier assets, the CBOE Volatility Index (VIX) -- the stock market's "fear gauge" -- collapsed by 26% on Monday. According to data from Schaeffer's Quantitative Analyst Chris Prybal, this dramatic VIX drop represents a signal that's flashed just three other times in history. Below, we'll take a look at what that could mean for the VIX and stocks going forward.

Short-Term Volatility Pop Ahead?

Specifically, the VIX has dropped 25% or more in one trading day just four times, the last occurring on Aug. 9, 2011, nearly six years ago. The other two signals happened in May 2010 and June 2006. "The VIX historically finds support after such declines when going out a month," Prybal notes, "after volatility rolls over and plunges."

Specifically, the VIX has averaged a one-month (21-day) gain of 10.7% after these signals, and was higher 67% of the time. Going back to 2000, the VIX has averaged a much smaller one-month "anytime" gain of just 2.1%, higher 45% of the time. If past is prologue, the market's "fear barometer" could be due for a short-term volatility pop, perhaps amid some short-covering, as Schaeffer's Senior V.P. of Research Todd Salamone recently discussed.

Looking out two months (42 days) after a signal, however, the VIX tends to underperform. In fact, the VIX was higher 0% of the time at the three-, four-, six, and 12-month markers, and was down an average of 37.5% a year (252 days) after a signal. That's compared to an anytime one-year gain of 5.3%.

A Summer Pullback Could Be a Buying Opportunity

But what does this signal mean for stocks? The S&P 500 Index (SPX) has underperformed in the short term following these signals, averaging losses through the two month point, and higher just one-third of the time. Since 2000, the SPX has averaged modest anytime gains in this same time frame, with a batting average above 0.550 across the board.

"After this consolidation, however, SPX returns far exceed the at-anytime lookback period," Prybal notes. In fact, six (126 days) and 12 months after a signal, the S&P averaged gains of 11.1% and 19.2%, respectively, and was higher 100% of the time. Since 2000, the SPX has averaged anytime six- and 12-month gains of just 2.1% and 4.3%, higher 66% and 70% of the time, respectively. In other words, if history is any indicator, a short-term dip over the summer could spell a buying opportunity for stock traders.