The VIX index and clues to the stock markets direction

If you’re not familiar with the CBOE Market Volatility Index the so called VIX, it’s often referred to as the “fear index” because of its tendency to rise when the market falls.

What it actually does is use prices on the S&P 500 Index options to measure the market’s expected volatility over the next 30 days. Below is a chart showing the VIX and the actual 30-day historical volatility of the market. As you can see, the VIX typically trades a bit higher than actual realized volatility. But recently, the historical volatility overtook the actual VIX. This is intriguing to us and so let’s have a look below at what occured in the market going forward.

Since 2000, the VIX has traded lower than historical volatility on 48 occasions. Below is a table showing how the SPX did following each signal. In the month after the signal, the average return easily outperformed what the market typically did (0.41% vs. 0.10%) and the percentage of positive returns were the same. Two months following a signal, while the average return still outperformed, the market was positive less than half the time.

What happened in a low VIX environment like now (16.74)? –

The chart below is encouraging. Specifically, it’s a chart of the SPX since January 2002, with the green dots signaling when the VIX was below 20 (as it is now), and the red dots signaling when the VIX was above 20. You can see that during the bull market from 2003 through 2007, these signals occurred with a relatively low VIX, and they were very good at marking the bottom of market pullbacks. Being in a similar environment now, it wouldn’t be surprising if this were a good short-term buying opportunity.

Below is the return data for the SPX since 2000, following the eight times the VIX was below 20 and actual volatility. It confirms what the chart shows: that these signals are very good buying opportunities.