Those of you that have been following my rambling discourse on the VIX over the past month already know that we've seen 3 months of unprecedented high levels of volatility in the markets. I've penned a couple of articles recently trying to ascertain what the VIX might be trying to tell us about what is happening, and more importantly, what might be about to happen. Since I don't want to rehash our prior discussions today, if you're just tuning in, be sure to check out the prior articles in this series.
I was looking for the VIX to break out of its recent 39-51 range to give some sort of indication as to whether to favor the upside or downside for the broad market. Remember that historically, a high VIX (above 30) has been a time to buy, while a low VIX (below 20) has been a signal to sell. Needless to say, those simple rules haven't provided much useful guidance over the past 3 months, as the VIX has stubbornly remained above the 30 level since the first week in July! Granted, my VIX charts only go back to 1994, limiting my field of view to bull market conditions, but late 1998 is the only other time period that showed sustained high volatility. And that period of VIX greater than 30 'only lasted for a little less than 2 months. So I continue to believe that we are in uncharted territory here.
In the past few months, we've had several instances where the VIX has spiked over 50, and we have had a couple of explosive rallies off the lows, the first one amounting to about 1545 DOW points and the second one delivering 1350 points so far. In all that time, the VIX has not cracked the 30 level. What could this strange behavior be telling us? Simply put, it tells us that option sellers are much more unsure of themselves (and the markets) are demanding a much fatter premium before they are willing to write those options. That's what the VIX always measures -- the degree of uncertainty or fear that exists in the marketplace at any given point in time.
By historical measures, we really are in uncharted territory, but that doesn't mean we can't use the tools we are familiar with to start charting this unfamiliar land in which we find ourselves. That is what I attempted to do in the prior two articles, and the way things have shaped up in the past week, it looks like we might have stumbled onto something useful.
Things started getting interesting last Thursday, with the VIX falling to the 38 level intraday, hinting perhaps that some of the fear was dissipating. But the action really heated up on Friday with the strong rally into the closing bell that drove the VIX down near the 36 level. I went into the significance of that move in the LEAPS commentary last weekend, and if you're interested in catching up, you can read all about it HERE.
The way I see it, something fundamental changed in the market late last week that caused a portion of that 'fear premium' to disappear EVEN BEFORE the strong afternoon rally. That hypothesis has been put to the test this week and I think it has held up rather well.
Comparison of S&P 100 Index (OEX) To VIX - 30 Minute Interval
Isn't it interesting how the VIX and OEX diverged late last week, and that divergence has continued this week. While the VIX found a floor (support) near 38 on Thursday, that level provided resistance on Tuesday, despite the fact that the OEX actually traded at a LOWER level than it did last Thursday and Friday. Certainly we would have expected the VIX to trade a bit lower on Monday, with the OEX moving slightly above the highs of last Thursday, but if everything had remained the same, the sharp selloff yesterday 'should' have driven the VIX back above 40. That didn't happen, and so we can reasonably conclude that something significant has changed.
I believe what has changed is that option writers are not as uncertain about the direction of the market as they were a week ago. That doesn't mean that I think we have a strong rally ahead of us. What it means is that those who are writing the options feel the risks of a dramatic selloff in the near term have been reduced. Perhaps it is expectations of an interest rate cut by the Fed, or maybe they are looking at the seasonal pattern where the markets have a tendency to put in a bottom in late October/early November. It could even be related to expectations of the markets behaving better heading into the mid-term election. One thing that I know isn't responsible is an improving economic picture. The abysmal Consumer Confidence numbers yesterday bear that out, and yet the markets rebounded and the VIX remained fairly muted, even on the early selloff.
Monday's low print on the VIX was 34.20, which marked its lowest level since August 28th. And turning once again to the Point and Figure chart on the VIX, the column of O's on the current Sell signal extended to 15 O's. Performing a quick vertical count calculation produces a 'target' of 19 for the VIX. Don't for a minute think that I give that target much credence. I think the likelihood of the VIX moving into the lower end of its historically normal range in the next 30-60 days is remote, at best. But we can't argue with the fact that the current VIX chart is the most equity-friendly it has been since late August. I would need to see the VIX moving back above 42 before I would be concerned that the 'equity-friendly' tone had appreciably changed for the near term.
Let's turn our attention to the bigger picture on the VIX and where it might be headed. Recently I've had several readers that have asked if perhaps the VIX is changing its spots and moving into a new permanently higher range. It's certainly a valid question, given the high levels of volatility we have seen over the past couple years. But there just isn't enough data to make that sort of assessment. Looking at a monthly chart of the VIX for the period of time for which Qcharts provides data shows periodic excursions out of the 20-30 range, from which it always reverts back to the mean. To be sure, this is the longest excursion out of the range that we can see on this chart.
Monthly Chart of the VIX
You can see in the chart above that the floor near 20 is very consistent for the VIX range, while we occasionally get excursions to the upside that become rather extended both in terms of magnitude and duration. While this chart is limited to looking back to mid-1997, I did manage to pull up a chart of the VIX on BigCharts.com that goes back to 1993. As you can see, the VIX was confined to a much narrower range between 1993 until early 1997. Then the VIX broke into its current 20-30 range that we are familiar with.
Weekly Chart of the VIX Going Back to 1993
So what would we need to see to make the statement that the VIX is moving into a permanently higher range? First off, we need to see the VIX come down and test the 30 level as support over a period of several months. We got that first test in August, and we might just get another test over the next few weeks. If we are going to label the VIX as having moved into a new, higher range, I would want to see from 3-5 successful rebounds from the vicinity of 30, without spending any significant time down in its historical 20-30 range. To make that determination, we're going to need more time. But if I had to hazard a guess, I would say the answer is no. I believe the VIX will eventually fall back into the range it has maintained over the past 5 years, although we will continue to have periodic excursions outside of that range.
The one big wild card in the whole shooting match is the makeup of trading volume in the equity markets. I believe a big part of the recent rise in the VIX is due to the fact that a much larger percentage of overall trading volume is coming from the proliferation of hedge funds and program trading. I think this adds to the volatility and that is reflected in a higher VIX reading. If we remain in an environment that is dominated by this sort of trading, then I would say yes, it is possible that the VIX is moving to a higher range. But, even in that case, we are going to need to see the passage of a lot more time before we can make a definite determination of the new/old long-term range for the VIX. Until then, let's stick with what we know for sure. And that boils down to trading as we have, based on the historical observations and looking for important inflection points in the charts like what we have seen over the past week.
I sure hope that helps! If you've got any questions on this topic, or another one that you'd like me to address in a future article, be sure to send me an email and I'll address them as time permits.
For all the rest of you big kids out there (like me), be sure to have a Happy Halloween!