Another Look at the VIX

May 2, 2009 

Maybe the Volatility Index (VIX) no longer matters. But if it does, the stock market is increasingly vulnerable to a resurgence of volatility--and a big drop.

Readers often ask my views on investing. I always say the same things: I do not offer advice, as I am not qualified to do so nor do I claim any qualifications or desire to do so. On occasion I share my amateur's opinions for free. Since nobody knows what's going to happen in the future, most commentators say that the safest position is cash/money markets or short-term Treasury bills, both of which pay near-zero interest. But at least capital is (more or less) preserved, though perhaps not when measured in currencies other than the dollar or in gold or oil.

I appear to be one of the last public Bears. I may well be proven horrendously wrong; perhaps the stock market will shoot up this coming week in a stupendously irresistable Bull Market. After all, the Bull case is persuasive: the market has built a base for the past month, technology stocks are rising, and tech always leads a Bull market; Asian stocks have broken out to the upside, and the U.S. economy is clearly on the mend, so now is the time to jump into the market before it skyrockets.

Despite the near-universal belief in all of the above, the VIX seems to be telling a different story--a story of near-euphoria and deep complacency.Let's consider the chart for a moment and ask: what parallels pop out of the VIX chart? It looks to me like all the parallels are to moments when complacency is interrupted by a return of volatility which reflects a sudden market drop:

A few things on the chart pop out:

 Though the price dropped to a new significant low in early March, the VIX did not hit a new high; instead, it continued its downward drift, exhibiting growing confidence and waning caution/fear/risk avoidance.

 The falling VIX formed a wedge which has broken to the downside, reflecting a near-euphoric decline in volatility. For better or worse, low volatility begets high volatility--something the market is currently ignoring.

 The measures of trends--ADX, -DMI and +DMI--tell an interesting story. The ADX is basically flat, indicating no powerful trend is at work. The -DMI which reflects negative trend is at levels associated with recent market tops.

 The flat MACD and trendlines strongly suggest complacency has returned with a vengeance and that market players/participants are feeling risk has vanished.

All of that sets the stage for an "unexpected" return of volatility. We have to ask: is this complacent chart reflecting the realities of the U.S. and global economies? Is this just another minor "recession" which is already ending? That's what this chart is reflecting. But if the economies of the world are not already "fixed" and ready to roar back to a 2006-like debt-fueled "prosperity," then that divergence between hope and reality could spark a renewed caution/fear which would show up in the VIX.

The financial Plutocracy and its media lackeys have been ceaselessly promoting the idea that this is a typical recession and now that's it lasted two quarters it's over; all indicators are turning up and a return to immense profits is just ahead, hence the rush to buy stocks before the Bull market really takes off.

But if the global debt/speculation/leverage machine is broken, and consumers of last resort i.e. U.S. consumers, are overburdened with debt and losing their jobs at a 600,000/month clip, then exactly who is going to be buying so furiously that stupendous profits are just ahead for corporations of all stripes?

Let's look at a chart of the Dow Jones Industrials. As noted on the chart:

 The compression of trendlines most notably marks periods of complacency which in hindsight are revealed as tops, not bottoms.

 The stochastic is dropping as each new surge of buying is less overbought than the previous burst of enthusiastic buying.

 MACD is telling an interesting story (at least to me). The last major uptrend in MACD ran up from Oct. 08 to Jan. 09, and yet price formed a wedge (higher lows, lower highs) which eventually broke to the downside. Now MACD is flatlined in indecision/complacency, much like August 08 just before a resurgence of volatility took the market down.

Frequent contributor Harun I. has noted that successful traders have a system which they have tested in the real world to confirm its value. Without a system, the trader has nothing but darts, luck and intuition. If a trader can't follow his/her system, then he/she will also fail. My system is flashing Bear signals which I am compelled to follow, knowing full well that I may be proven completely wrong. (If there was any system which perfectly predicted the future, we'd all be millionaires.)

Two other considerations weigh on the upcoming break up or down.Legendary trader Jesse Livermore opined that the market will take along the fewest possible participants. Others have phrased the idea thusly: the market will extract the greatest amount of money from the greatest number of participants possible.

After weeks of drifting higher and a VIX plumbing the depths of the lower Bollinger bands, it seems Bears are scarce to the point of extinction. Thus I conclude that the move which would take along the fewest participants at this point is a violent downdraft which did not allow players to get short and join the ride.

I also note that true Bull markets are rarely if ever launched by V-shaped spikes and recoveries like March of this year; price must re-test the previous low and form a double-bottom before participants can be confident the bottom is actually in.

The charts are saying that the Bulls are absolutely confident to the point of euphoria that the bottom is in and it's all up from now on. Maybe that will transpire, but I am compelled to bet the opposite will occur.

Remember, this is just an amateur's opinion, it is not investment advice; please read the HUGE GIANT BIG FAT DISCLAIMER below most carefully. 


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Our previous list of hot reading (check them out at your local library if you don't want to own a copy) can be found at Books and Films 

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