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Improving signs for the stock market

Expectations of market volatility have dropped. The Volatility Index is Stock Trends Bearish; the S&P 500 index is about to turn Stock Trends Bullish. Is this a good time to be in equities?

January’s market advance has offered a fresh hope for equity investors. The S&P 500 is up almost 5% in 2012, while the S&P/TSX Composite has advanced 4%. Another sign that perhaps signals a launch for markets ahead is shrinking market volatility. The CBOE Volatility Index (VIX) has dropped steadily from its peak in the autumn last year, and is now a Stock Trends Bearish Crossover . With the S&P 500 index now verging on a Bullish Crossover , this inverse relationship between market advances and dropping price volatility expectations may be a supporting signal of continued bullish trending for stocks.

The VIX measures the implied volatility of a range of S&P 500 options over the approaching 30 days, and is broadly used as an indicator of the market’s expectation of price volatility over the next month. This index is more accurately understood as an oscillator, with a mathematical expectancy of ‘mean reversion’. That is, although the index will fluctuate between ‘high’ or ‘low’ readings, it will revert to its mean, or average, level once it has peaked or troughed. This mean reversion reflects the market’s long-term expectations of volatility. Even in extremely volatile moments of market crisis, time and information tend to deflate investor anxiety; even in the calmest moments of complacency, the future invariably delivers market crisis. This is one of the truths of the investment world. It is a truth in life, too.
 

Inverse correlation of trend between the CBOE Volatility Index (VIX) and S&P 500 Index

 
 

 

 

 

Now that the VIX has returned to its mean level, how meaningful is its current Bearish Crossover indicator? If we look at the record of the past 16 years, the market has showed intermittent correlation with VIX Bearish Crossovers. The table below shows the performance of the S&P 500 index after the VIX turns Stock Trends Bearish with a Bearish Crossover  until it returns to a Stock Trends Bullish trend as a Bullish Crossover .
 
Of the 13 previous VIX Bearish Crossovers during the period - which would represent times when the intermediate trend (13-week average) of the Volatility index had returned back to its long-term average level (40-week average) – three VIX Bearish Crossovers were followed by significant positive returns for the S&P 500 index. Although the VIX Bearish Crossover signal was also followed by three significant drops in the S&P 500, in one of those occasions (June 15, 2001, prior to 9/11) the VIX Bearish Crossover was matched with an established Bearish trend for the S&P 500. The other occasions, January 4, 2002 and May 16, 2008, preceded major market collapses.
 
Overall, the inverse correlation of the VIX Bearish Crossover  as a market-timing indicator appears substantiated when the matching S&P 500 trend is either Bullish or Weak Bearish - as it is now. The current market conditions – supremely affected by the far-from-resolved Euro crisis and the U.S. election cycle – suggest that this recent lull in market anxiety will be positive for equities. The VIX tells us now is the time to be in stocks again.
 
 

Performance of the S&P 500 index

during a VIX Stock Trends Bearish trend

Date

VIX

ST Trend

VIX

Price

S&P 500

ST Trend

S&P 500

Price

 S&P 500

% Chg
10/11/96 15.51 700.66  
12/13/96 22.26 728.64 4%
2/20/98 19.55 1034.21  
8/21/98 31.91 1081.18 5%
1/08/99 23.88 1275.09  
2/18/00 28.45 1346.09 6%
8/04/00 21.54 1462.93  
11/24/00 29.58 1341.77 -8%
6/15/01 26.33 1214.36  
9/28/01 35.19 1040.94 -14%
1/04/02 22.02 1172.51  
7/12/02 38.33 921.39 -21%
1/10/03 27.13 927.57  
5/13/05 16.32 1154.05 24%
7/15/05 10.33 1227.92  
10/21/05 16.13 1179.59 -4%
12/02/05 11.01 1265.08  
5/26/06 14.26 1280.16 1%
10/13/06 10.75 1365.62  
3/30/07 14.64 1420.86 4%
5/16/08 16.47 1425.35  
9/19/08 32.07 1255.08 -12%
4/17/09 33.94 869.6  
5/28/10 32.07 1089.41 25%
10/01/10 22.5 1146.24  
7/29/11 25.25 1292.28 13%
1/20/12 18.28 1315.38  
 
Published in Stock Trends