Thursday, October 29, 2009

The VIX in Relation to the Stock Market

Empirically, it is observed that volatility of stock price movements correlates positively with declining prices and negatively with rising prices. The mathematics do not make it necessarily so, but the relationship keeps on holding cycle after cycle. A common measure of the volatility of stocks is the volatility index, symbol VIX. In typical bull markets following bear markets, volatility declines below 20 and if the bull is sustained, may reach or drop below 10. In the turbulence of the late 1990s through 2003, the VIX was however range-bound between 20 and 40. Last year, the VIX went to an ultra-high level above 60. The peak of the recent rally took it almost to 20. I noted recently on this blog that the famed second derivative of the VIX had turned positive, meaning that the rate of decline was continuing to slow. Above are one-year and long-term views of the VIX.

What my eye sees from the one-year chart is unfavorable for the stock market, except that short-term, the rapid move up on the VIX the past 2 days is "too far, too fast" and "deserves" a pullback, implying a rally in stocks. The long-term chart is also worrying. Correlating with geopolitics and the economy, the volatility at the end of the 1980s (not shown) and into the recession of 1990 and Iraq War of 1991 was followed by a decade of peace and prosperity. The average stock peaked in 1997-8 concomitant with the then-current global financial crisis. The Fake Recovery that began after the 2001 recession ended also had a massive drop in the VIX, followed by an even more massive record sustained rise in it.

The VIX over the past few months is making the same sort of bottom that many stocks and markets have made this year. Of course, one never knows, I respect evolving trends, especially ones that the media do not discuss. As a guidepost, I have noted the past 2 years that for some reason, 25 is a VIX number to respect. Under 25, stocks do poorly. Over 25, look for a bounce.

Because I believe that the charts suggest that stocks are in a structural bear market, I am inclined toward the hypothesis that the VIX has entered another multi-year period similar to 1998-2003. There were two single-best investment strategies in that time period. One was to buy Treasuries when yields rose. The other was to go with the hot sector that appeared to have good fundamentals. That meant buying not value but the breakout to new highs, whether it was the tech sector in early 1999 or the Russell 2000 in 2002. The safer and simpler approach was to avoid stocks and stick with gold, bonds and cash. I am still mostly doing that now, though that was a time of governmental fiscal restraint following the Perot movement.

People who own more stocks than they would be comfortable owning if the stock market dropped another 10-15% from here may want to lower their exposure the next time the VIX drops under 25.

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