One of the things that make the
CBOE Volatility Index
(VIX) such an interesting indicator of the market is that it represents volatility and not an actual stock price. Its value is expressed in percentage points, not dollars. Because it is a measure of volatility, it exists in a different world than traditional stock indexes. While in very short-time frames stock indexes will have some pull toward mean reversion, called a sideways channel, in the long term, indexes go where they please (hopefully up).
If you were to ask what the average price of the S&P 500 will be over the next 10 years, the answer would be 'your guess is as good as mine'. If you were to ask what the average price of the VIX will be over the next 10 years, I could come within one point of the correct answer by saying 20.00. The VIX mean reverts, the SPX doesn't. This is why it can be such a powerful weapon. To make matters better, when the VIX is elevated or depressed it will have mean reversion, within long-term mean reversion. We start by taking a look at a one-year chart of the VIX to see how it can have short-term mean reversion.
1. Low volatility, low volatility of volatility, reversion to 17%. This is an especially calm period of time in which we saw little market movement.
2. An incremental increase in volatility with the mean of VIX near 20 (its long-term mean), we saw an increase in volatility of volatility.
3. High volatility of volatility, not discernable pattern. This was the markets warning sign that all is not well. We saw similar price action of the VIX in June and July of 2008. A choppy uncertain VIX with no discernible mean should be traded with HIGH caution.
4. Spiking VIX, high mean of VIX near 40%, and high volatility of volatility (one might notice that when the VIX is high, its volatility of volatility is also high). When VIX is twice its mean price and is taking large daily swings this is a clear sign to stay away. We will get into why not to buy in this time period in a few.
5. Step down. The VIX is calming down, volatility of volatility is calming down. Once we see that the VIX in no longer hitting higher highs and is actually touching lower lows. The VIX has begun to take steps down. We are in this period currently. This is also the time to begin to accumulate positions on bottoms of SPX (or when VIX is topping near 35%.)
Honing in on the last three months let's look at October 3 and 4, the low close of the SPX and the intraday low of the market. Notice in the circled area that despite a relatively large sell off in the SPX of 33 points, VIX itself barely budges on October 3 and then with the market pop on October 4 completely plunges. This was a clear sign that we were coming out of 'panic mode' and into a new period, the step down.
Looking at the above, pattern in which the VIX barely budges on a low and then falls hard on any kind of rally, I think we have a major market bottom forming at 1190. Again we saw the market selloff quite significantly, yet VIX is unable to break 35% and hold, and we see implied volatility falling on a down market. This is a clear sign of a market bottom in both price and volatility. Looking deeper, a clear indication of market apathy is how low VIX is relative to SPX price.
On Day 1 we see the SPX is trading 1230 and the VIX is at over 36. Day 2 we see SPX trade below 1220 and VIX trading below 35. Day 3 (today) we can see VIX trading 31.5 and SPX trading around 1190. This is a clear pattern of divergence in VIX and SPX and a sign of a bottoming market. We should see a major negative correlation of VIX to SPX. Instead we are seeing the two indexes correlate.
Getting back to mean reversion, in the near term a VIX of 30 has been a floor. I think the market is setting up for another 'step down' in volatility where VIX will hang out between 25-30 and the market will meander UP instead of down. We will know if there is a step down if the VIX meanders through 30 (as opposed to dipping on a big rally). This sets up a bullish cycle in the market similar to what we saw in October (# 1 below). If this all falls into place we could see the S&P 500 break 1300 and the VIX touch 20.
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At the time of publication, Mark Sebastian held positions in VIX.