Analyzing the VIX

247Bull.com Editor: The VIX is a measurement of market sentiment. It tends to rise during periods of fear and uncertainty, and decline during periods of confidence or complacency. The VIX is now at a 69 month low, so the question is, does this signal the beginning of a new bull market or an impending market top? One analyst who is not concerned about the low level of the VIX is respected market technician Louise Yamada. According to Louise, the VIX being under 20 has generally been a good sign for equity markets, and investors should worry when it begins to spike back above 20 as it did prior to the market top in 2007. A short-term market correction looks likely, however the longer-term picture points to higher prices for most risk assets. The old adage of “don’t fight the Fed” has never been truer.

The VIX (Volatility Index) is a good measure of fear, or lack thereof, in the stock market. It is constructed by measuring the amount of premium on a select group of put and call options. When options writers are more fearful, they charge a higher premium, which translates to high VIX readings. Low VIX readings are evidence of complacency.

A subscriber recently called my attention to a chart from KimbleChartingSolutions.com which shows a six-year chart of the VIX compared to the SPX. Below is our version of that chart, highlighting the market action that occurred when the VIX reached current low levels.

When I see such reliable repetition, I immediately want to see how the indicator behaves over a longer period. There is, for example, that very low reading on the left side of the chart. What’s that about?

Below is a 20-year chart of the VIX and SPX. We can see that there was another period between 2003 and 2007 when the VIX was good at picking price tops upon reaching a level similar to the most recent five years — about 15. Unfortunately, there were two extended periods (circled) when the VIX carried much lower readings — about 10 — and was much less useful in identifying price tops. Another observation is that these periods were associated with bull markets, which probably reflects strong investor confidence at the time.

The current VIX reading is lower than any reading since 2007, so we must wonder if the VIX may be descending into another extended period of bull market confidence, characterized by a lower VIX range with a bottom of about 10. We can’t rule that out, but we have so many other indicators that are overbought and long-term overhead resistance at about 1550, that my best guess is that the VIX is warning us of an impending price top, not the beginning of a new bull market era.

The main thing to be learned is that indicators can behave one way for an extended period, then change and behave entirely differently. Always try to find a longer-term chart to see if current behavior is typical or subject to change.

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