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Kass: Get Ready for the Fall

One of my favorite ways of measuring investor sentiment is by looking at the ratio of bulls/bears who appear on CNBC, the degree to which the bulls are emboldened and even glib after a relentless market advance (like the current one of six to seven weeks) or when the bears preach the end of the world after every 5% to 7% correction.

But my favorite way of measuring investor complacency is by observing the VIX.

The VIX was originally introduced by the CBOE in 1993. At that time, it represented the weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. In 2003, it was expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors' expectations of future market volatility.

VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

The VIX closed last week at a multiyear low of 13.45. (It edged up to around 14 in Monday's trading.)

As can be seen in the two charts below (which compare the VIX to the S&P 500), the VIX is an uncanny forecaster of market tops and bottoms. A high and peaking VIX typically indicates a market bottom and a low and bottoming VIX often spells out a market top. (Hat tip to Barry Ritholtz's Big Picture blog for the charts.)

This month is the fifth time in over two years that the VIX has hit 15.0 or below (The blue circles in the first chart below indicate points of time in which the VIX closed the week at under 15.0.)

As seen in the next chart, each time the VIX made a low of around 15 or less, the S&P 500 made a decisive short-term peak (again indicated by the blue circles).

Typically, the decline in the markets, off of a low VIX is quick and relatively severe. On average the S&P dropped by about 10% (and took about two months to correct), with the smallest decline of 6% in February 2011 and the largest drop of 19% in July 2011. (If we go further back in history, the same relationships hold; complacent markets are almost always associated with market peaks and vice versa.)

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Chart of I:DJI
DOW 17,750.91 -140.25 -0.78%
S&P 500 2,063.37 -18.06 -0.87%
NASDAQ 4,763.2240 -54.37 -1.13%

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