The Volatility Index (VIX) is a great tool to measure sentiment within the equity market. The VIX is often called the ‘fear index’ since it rises as traders buy options to hedge or protect their portfolio against a future possible decline in equity prices.
Oftentimes the Volatility Index is historically high when the S&P 500 hits a bottom, due to a large influx of traders bidding the index higher with an increase of ‘fear’ of declines in the large-cap equity index taking hold.
CURRENT ACTION
With the S&P 500 currently being considered ‘oversold’ by various technical indicators and market participants, we have not seen the inverse reaction in volatility, with the VIX sitting under 16.50 at the end of last week. We can assume with this low of a VIX reading that traders have not been buying protection for their portfolios, making the assumption that there isn’t a build up of ‘fear’ in the equity market. David Rosenberg made a similar observation in his Breakfast with Dave note on November 16th, “In the eight corrective phases we have seen in the tired four-year old cyclical rally, none bottomed without the VIX index hitting the 27 level at a minimum. On average, the market bottomed with the VIX at 33. The fact that the VIX closed at 18 tells you that there has not yet been enough “fear” to generate a full-fledged panic low to start jumping on.”
HISTORICAL ANALYSIS
To see if the S&P 500 had bottomed after a similar decline with volatility this low, I looked at levels of the VIX at market bottoms in the S&P 500 after periods of 7+ percent declines (since we are currently down approx. 7%). Since 1993, there is only one other instance (1995) where it was trading under 16.50 after a 7+ percent drop.
NO MARKET BOTTOM YET
So while it does seem that a period of consolidation or appreciation is due for equities, there does not appear to have been enough ‘fear’ to equate to a market bottom. We’ve also yet to see the ‘smart’ money’ that we discussed last week shift any more net-long in S&P 500 futures like we’ve seen over the past few years at market troughs. Commercial traders actually went more net-short over the previous week, not what equity bulls were hoping to see.
Over the next few weeks traders are looking for a short-term bottom to be put in for equities, and I wouldn’t be surprised if we got it. However, it doesn’t appear we have experienced enough destruction and fear to make our way to new highs in the major indices without first seeing lower stock prices and a higher VIX take hold.
Disclaimer: The information contained in this article should not be construed as investment advice, research, or an offer to buy or sell securities. Everything written here is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned.
