Nasdaq spikes higher
Japan jumping
Predictably, the bears remain largely defiant. This is merely the calm before the storm, they insist. To support this claim, they point to the state of the VIX index, which measures how much volatility traders expect in the S&P 500 over the next 30 days. The VIX dipped to 10.34 at the end of last week, its lowest level since February 2007. This suggests that traders are counting on the recent stability to extend into the near future, which to pessimists suggests dangerous complacency, as it did seven years ago, just before the credit crunch bit.
Placid VIX
It is certainly true that major highs in the S&P 500 have often followed very low volatility readings. But it is also the case that periods of low volatility can last for extremely long periods indeed. During the last bull market, for example, the VIX’s reading stayed around similar levels to today's from the end of 2004 to early 2007. Much the same happened in the early 1990s, when the stability went on for some five years. Any trader unwise enough to exit the market through fear that the calm would give way to a storm would have foregone massive gains.
Is the VIX's reading of any use at all when it comes to warning of reversals in the market? According to Tom McClellan (www.mcoscillator.com), the really big tops in the S&P have typically been heralded by an upturn in the volatility from very low levels. In 2007, for example, the VIX began to surge in the spring, whereas the market didn’t peak until October. Ahead of the bursting of the technology bubble in 2000, the VIX also experienced some big spikes. The brief bear market of 2011 was also preceded by a jump in volatility.
Going by this logic, therefore, the S&P is not about to form a top. The VIX first needs to surge for this to happen. I am not sure if I buy into this completely. The volatility index only goes back to 1990, so we only have a handful of examples to draw upon. Another problem is the many 'false positives' that have flashed up: surges in volatility from low levels that were not followed by any lasting damage whatsoever, such as in 1992, 1996 and 2006.
S&P buying level
Besides signalling major tops in advance, Mr McClellan also believes that the VIX may help flag up much lesser highs in the market. Specifically, he thinks that divergences between the two can give "a hint of a brief change in direction". The set-up he looks for happens when the S&P 500 has been making new major highs and the VIX lower lows, followed by the VIX turning upwards even as the market makes further fresh highs. There have been some signs of this just lately. Even if he is right, I rather suspect that another buying opportunity will ensue shortly. A bounce off the 50-day average would do nicely here.
