I have a smaller topic relating to the best months for gains on average and a larger topic on the usefulness of the VIX in market timing
. I've tended to not use the VIX much as a Market 'timing' indicator and a recent study (Birinyi Associates) suggests that it has "limited predictive
value"; or is it quite that simple?
SEASONAL TENDENCIES FOR MARKET GAINS
Speaking of indicators, a couple I do tend to rely on for suggesting impending market corrections arenâ€™t of much use in major 'bit in the teeth' run ups characteristic of occasional power moves; 'wave 3' rallies in (Elliott) Wave terms. These type rallies tend to occur when there is a perceived shift in the fundamental outlook for stocks. Technical analysis, I sort of hate to say, is of limited use in predicting just when a correction is going to happen in these type prolonged rallies.
If I was looking for a tradable correction (e.g., a 3-5% or more pullback) in early-April due to such factors as 1.) the end of the buying associated with the Q1 'window dressing' period, 2.) an 'overbought' market with 3.) bullish sentiment being extremely high, I was barking up the wrong tree by not also taking into account a strong seasonal tendency for April gains.
In terms of a 50-year look back at the market, based on average gains in the Dow 30 (INDU), the best Market months in terms of average gains have been:
THE VIX AS A MARKET PREDICTOR
I need to start with a definition and some background on VIX in case you arenâ€™t overly familiar with what VIX is and how it is perceived. If this is too elementary for you Dr. Watson, you can skip this section.
First off, VIX is widely perceived as a contrarian 'sentiment' indicator that helps to determine when there is too much optimism or fear in the market. When sentiment reaches one extreme or the other, the market is anticipated (typically) to be susceptible for a trend reversal, even if only a minor counter-trend move.
The VIX is based on data collected by the CBOE (the Chicago Board Options Exchange). Each day the CBOE calculates a figure for a 'synthetic option' based on prices paid for puts and calls. The computation of the VIX was changed in 2003 and is now based on the S&P 500 option series. (VXN measures various stock options that are part of the S&P 100 Index.)
The key question the Volatility Index answers the question about what is expected, that is 'implied' volatility of this theoretical synthetic option based on the variables of: 1.) the SPX price, 2.) prevailing interest rates, 3.) number of days to expiration of the option series and 4.)the strike prices of those options series.
The equation used solves for an 'implied' or expected volatility or the potential for limited versus expanded price swings; or, how FAST prices move. When the market is calm and moving in a trading range, or moving higher or lower in a steady fashion, volatility is typically low. This kind of market typically reflects complacency, or we could say a lack of fear of sudden and frequent reversals.
Conversely, when the market sells off strongly, anxiety among investors tends to rise. Traders tend to rush in to buy puts, which in turn pushes the price of these options higher. This increased amount investors are willing to pay for put options shows up in higher readings on the VIX. High readings typically represent a fearful marketplace. In a contrarian sense, an oversold market that is filled with fear at some point will often turn and head higher.
A CONTRARY VIEW OF VIX'S 'PREDICTIVE' VALUE
Laszlo Birinyi is a stock analyst that is very empirically oriented and by the way someone who tends to be skeptical of technical analysis. I respect his research-oriented approach nevertheless. About 6 weeks ago he made some news in a report to clients cited in Business Week to the effect that Investors looking for clues about the U.S. stock market should probably ignore the Chicago Board Options Exchange Volatility Index (VIX).
Speculation that equity returns will be positive after the volatility gauge decreases and negative when it climbs has "little basis in fact", Birinyi said. "The VIX provides a summary of historical price swings and tends to move in lockstep with equities instead of forecasting their direction", his firm's report, Birinyi Associates, indicated they found in studying the issue.
THE BIRINYI STUDY:
"The VIX is alleged to be an indicative indicator and has become a staple of analysts and journalists alike. We respectfully disagree and ultimately conclude it (the VIX) is a measure of current volatility with little or no predictive or indicative value regarding the course of the market.
The Standard & Poorâ€™s 500 Index gained an average 0.1 percent in the month after the VIX slipped 20 percent below its 50-day mean on 12 occasions since 2003. Stocks were 0.5 percent lower after two months and 3.3 percent higher after three. When the VIX climbed 20 percent above its 50-day average on 18 occasions, equities increased after one, two and three months, then dropped after six.
The VIX is a coincidental indicator. It details, perhaps better than other measures, the volatility of the market today but not tomorrow or the day after." One analyst, David Darst of Morgan Stanley, was also quoted in the Business Week article: "Thereâ€™s this saying on the floor of the CBOE that when the VIX is high itâ€™s time to buy, and when the VIX is low itâ€™s time to go slow. Thatâ€™s been a famous traderâ€™s rallying cry for years and years."
There is one thing here that we ought to also consider about the use of VIX as a LONG-TERM investment oriented predictor (Birinyi's bread and butter) versus a SHORTER-TERM trading indicator which is more of our focus as options traders.
MORE ON VIX AS A 'REVERSAL' FORECASTER
After spending some time looking at the VIX relative to the S&P 500 (SPX) at least over the past 6 months, I see some interesting correlations of VIX as a contrary indicator at some key turning points in the market as highlighted below. In terms of exact market 'timing' as to reversals, it couldn't stand on its own exactly. But, used in conjunction with price patterns, especially that suggest reversals, and other indicators showing extremes such as the RSI and sentiment indicators, VIX is starting to show me some definite value. But, what about currently?
The most recent example of low VIX readings has of course been accompanied by a continually rising market. I think MORE is needed in terms of using VIX has a shorter-term indicator warning of a possible downturn. Of course, there are always instances where indicators just don't 'work' in suggesting an impending trend reversal.
Currently, the VIX is as low as it's been in nearly two years, leading some to believe the market is headed for at least a substantial pullback. This could be true but maybe not. Using the VIX as a contrarian indicator in ALL instances may be great in theory, but not always accurate in practice.
The VIX index is at 16.48 today. This is low relative to my chart above, but it represents a limited period also. Since the VIX began in 1990, the median reading is 18.8, so today's level is perfectly average. This does not account for the 2003 change in the VIX computation however.
Lets assume that the VIX is low, does that mean the current situation will be like past times when the VIX was low and stocks subsequently fell. You can also find periods when it was low by historical standards and stocks went on to surge for months and years more.
Still, VIX remains a popular tool for traders who use the VIX to gauge levels of fear or complacency in the market and specifically in trading the SPDR S&P 500 (ETF) as well as trading the Volatility Index itself through instruments like the iPath S&P 500 VIX Short-Term Futures (ETN).
As to traders looking at low VIX levels as potential opportunities to buy and high VIX levels as potential opportunities to sell or sell short, Birinyi's research suggests that it is time for this tradition to pass. Birinyi Associates looked at the performance of the S&P 500 when the VIX was trading above its 50-day moving average and when the VIX was trading below its 50-day moving average.
Research done by Connors Research has done shows something quite the contrary. When used 'properly', their conclusion is that the VIX remains a useful, if not excellent tool, particularly for short term traders, when they compare the VIX to itself over the short term; e.g., comparing the VIX to a 10-day moving average of itself. The trick is to see the VIX as a dynamic indicator, not a static one.
Larry Connors observed that "since 1995, whenever the VIX has been 5% or more above its 10-day moving average, the S&P 500 has achieved returns which are better than 2-to-1 compared to the average weekly returns of all stocks."
Conversely, "when the VIX is 5% or more below its 10-day moving average, the S&P 500 has tended to underperform for the next five days. This research is also since 1995.
I decided to set this up on a VIX chart below, using a 10-day VIX average with a moving average 'envelope' that plots a line that is 5 percent above and 5 percent below a 10-day moving average of VIX.
The above model may narrow down forecasts for when the market should advance (VIX greater than 5% over the VIX 10-day average) or is due to 'under-perform' or decline (VIX falls 5% or below the VIX 10-day average). However, this same model would have led us astray if we have gone into puts when recent 'bullish' readings have occurred, specifically in mid-February and in early-March.
This recent predictive failure for the above indicator brings me back to the limitations of technical analysis in forecasting reversals in the occasional prolonged 'power moves' to the upside. It has been easier to forecast times to do further or renewed buying within overall major and strong uptrends. Still, the above model is an interesting one and I'll pay some attention to it in the future but in conjunction with the charts and certainly not in a 'mechanical' way.
GOOD TRADING SUCCESS!