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Volatility Overload\?

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Volatility Overload?

The topic of volatility has gotten a lot of press time lately,and small wonder with the VIX topping the 40 level (at least on an intraday basis) earlier this week. Volatility certainly wasn't lacking today, with the broad market moving sharply lower at the open and then staging an impressive afternoon rally. The S&P 500 swung from a low near 845 to a high of 868, before settling near with a respectable (if small) gain on the day. The VIX has had its share of volatility in the past few days as well, and I thought tonight would be a good time to discuss these movements and what possible implications they could hold for the near-term future of our beloved markets.

Before we get into the meat of the discussion, let me point out that I never use the VIX as a primary indicator of market direction. The main reason for this is that the VIX is derived from action in the options market, which is a derivative market of actual price action in the stock market. Therefore, trying to divine future market direction based on the action of the VIX is really the study of a secondary indicator. The real action is what is occurring in the price action of the broad market averages, and measuring that will provide a more direct measure of what to expect. Having said that, I often find that studying the action of the VIX provides a great confirming indicator of what I see in the broad market.

So let's start with the backdrop that the major indices still look exceedingly weak, even after today's rebound. PnF Sell signals abound, Bullish Percent charts are all tilted significantly in favor of the bears, significant support levels (at least in the DOW and S&Ps) have been violated, along with H&S breakdowns that have been highlighted by others for weeks now. Add in the prospects of war, and an economy that looks sick, at best, and it is hard to make a convincing case for a rally that has much future, at least in the near term. But I don't want to get diverted to any of those issues this afternoon. I want to talk about the VIX, show some of the different ways of viewing this indicator and how it might be used to confirm the bearish picture for equities.

In his 3:15pm intraday update on Monday, Kent Barton pointed out a long-term trend of lower highs in the VIX since the July highs near 57. That chart really got my attention, as it looked like something important. That descending trendline worked out to just over 41 (as shown below) and it is really interesting that this trendline acted as firm resistance this week.

Weekly Chart of CBOE Volatility Index (VIX.X)

In last Sunday's LEAPS column, I discussed my belief that the range for the VIX really IS rising, due to the persistent rise in the 200-dma, which I have approximated in the chart above with a 50-week moving average. This average is now at its highest level ever. That tells me that the historical range between 20-30 no longer holds the significance that it once did. I even stated my belief that a VIX reading in the teens is probably something we won't see for a period of years. Coming back to the VIX reversal at that descending trendline, I actually was surprised to see that reversal. Whenever the market surprises me, I like to find out why. Or in other words, what is it that I missed?

When looking for the big picture, I frequently turn to the PnF charts, as they show me the dominant supply/demand dynamic at work. This even works for the VIX, and look what I found!

Point & Figure Chart of the VIX

On the PnF chart, the bearish resistance line was at 40. Do you think it is just a coincidence that the VIX was unable to print 41? Neither do I. By the way, the intraday high for the VIX was 40.89 on Monday, just 0.11 shy of the 41 level, but shy just the same. Those familiar with PnF charts know that the first test of bearish resistance usually results in a reversal, just as the first test of bullish support results in a reversal. That held true with the VIX this week and I am now looking for support to hold in the 33-35 area. As you can see, 35 is significant support for the VIX both on the PnF chart and on the standard candle chart, as this area acted as resistance throughout December. Defining the lower edge of this support zone is the 200-dma, which now sits at 33.23.

One thing on the PnF chart that tells me up is the dominant direction for the VIX is that we now have a strong Buy signal. Performing a vertical count gives a target of 67. Wow! That seems extreme, doesn't it? But just a few months back, I never would have believed the VIX could remain above 30 for a period of 4 months, either. Things change.

As I said above, I don't use the VIX as a primary trend indicator. I use it for confirmation. But in the context of a market that clearly seems to be heading south, the VIX certainly appears to be providing that confirmation. Let's look at one more chart to round out our discussion.

Weekly Chart of CBOE Volatility Index (VIX.X)

Here I've shown the same weekly VIX chart, but with a few more pieces of information. With the normal range of 20-30 shown in blue, it becomes easier to visualize how far the VIX has deviated from its normal pattern. That double-bottom near 26 perhaps defines a new floor for the VIX, and certainly did so earlier this month. I normally don't pay much attention to oscillators on the VIX, as I've found the gyrations rather difficult to interpret. But one aspect of the Stochastics as applied to the VIX that I have found useful is that of divergence. It doesn't occur very often, but when it does, it seems to be pretty consistent about forecasting major moves. So it is perhaps useful to note the higher lows in Stochastics, as compared to the equal lows for the VIX -- bullish divergence, and that is bearish for equities, once again confirming my broad market view.

Certainly, the picture afforded us by the VIX right now is subject to change, but it does provide a good confirmation of the bearish picture currently being displayed in the equity market. Hopefully this little discussion helps you to see how I use the VIX to keep on the right side of the dominant trend. In my view, the big picture being displayed both in the broad market indices and the VIX is telling me that the market is heading significantly lower and the VIX significantly higher before a new tradable bottom will be in place. Questions are always welcome.

Mark



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