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Extreme VIX Reading Signals Turnaround

One thing the recent market weakness has accomplished is to turn consensus opinion firmly bearish. There is no doubt about it. Sentiment, as measured by the VIX, has made an extreme move on a long-term basis, and it may be another signal that this market has gone about as far as it can to the downside without some lift occurring first.

The VIX is simply a measure of fear, as volatility is a nice-sounding word for fear. When the consensus becomes this one-sided, the probabilities of a swing the other way and a reversion to a more median reading in the VIX away from the recent extreme, increases significantly.

Market Volatility Index
Click here for larger image.

In a normal world, most price movement is contained to about two standard deviations. The VIX has moved out beyond four standard deviations of the 200-day moving average. A four-standard-deviation move away from the 200-day moving average marks an extreme move that we have seen in only 11 previous situations. The market has shown a strong upside bias once a signal has been reached.

Many technicians have looked at this selloff and are predicting the start of a bear market. This may be the case, but it's just a guess, nothing more. The market is oversold, as measured by our 40-day SARSI indicator, the uptrend channel for this rally remains intact, the long-term trend for breadth remains intact and sentiment is at a rare bearish extreme. All the signs for a bullish reversal are there.

If this is the start of a bear market, you won't know until the rally plays out. The decline isn't the key, the rally is. We would watch for a weak countertrend type of move back toward the prior highs to start getting bearish, not now with every bullish reversal signal in the book flashing "buy."

S&P 500
Click here for larger image.

If we go back and look at each occurrence of a four-standard-deviation move in the VIX, in most cases it was "the" low. This is cold comfort when the market is acting as heavy as it did today, but traders should keep this in mind.

The sentiment picture is about as bad as we have ever seen it. The selling has been brutal, but if we look at the longer-term charts for the major indices, surprisingly little damage has been done. The reason for this is that the distribution of stocks started in May. The market weakened internally starting in May, and this 10% correction has been the last-stage "blow-off" to the downside.

The possibility of this being the start of a bear market is present, but there simply isn't enough information to make that determination. The market will rally and that rally will give us the clues we need to decide if this is an old bull or a new bear.

VIX Four-Standard-Deviation Move
Date S&P 500
Level
1
Week
%
Gain
1
Month
%
Gain
2
Months
%
Gain
3
Months
%
Gain
10/5/1992 407 409 0.491400491 418 2.702702703 435 6.87960688 434 6.633906634
4/4/1994 438 446 1.826484018 451 2.96803653 460 5.02283105 446 1.826484018
3/8/1996 633 651 2.843601896 644 1.737756714 644 1.737756714 673 6.319115324
7/16/1996 628 626 -0.318471338 665 5.891719745 683 8.757961783 704 12.10191083
10/27/1997 876 942 7.534246575 955 9.01826484 953 8.789954338 969 10.61643836
9/11/1998 1009 1023 1.387512389 997 -1.189296333 1120 11.00099108 1166 15.55996036
4/17/2000 1401 1464 4.496788009 1447 3.283369022 1486 6.067094932 1510 7.780157031
9/20/2001 984 1038 5.487804878 1089 10.67073171 1142 16.05691057 1139 15.75203252
7/23/2002 819 911 11.23321123 962 17.46031746 845 3.174603175 890 8.669108669
6/13/2006 1236 1252 1.294498382 1242 0.485436893 1266 2.427184466 1313 6.229773463
Average
Returns
3.627707653 5.302903928 6.991489499 9.14888872

Hughes and Maragioglio co-founded Epiphany Equity Research, which has developed and utilizes proprietary tools to identify and track liquidity changes in the market indices and sectors. Hughes advises numerous asset managers, hedge funds and institutions managing in excess of $30 billion. Maragioglio is a member of the market technicians association (MTA) as well as The American Association of Professional Technical Analysts (AAPTA) and holds a Chartered Market Technician (CMT) designation. Maragioglio has also served on the board of directors of the AAPTA.

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