Now that the market has rebounded close to the all-time highs hit in January, should investors fear another big swoon, or play for a fresh breakout?
Sebastian and Cramer began by looking at charts of the Volatility Index, also known as the fear index, and the S&P 500. Normally when stocks are moving higher, bulls want the VIX to be going down.
In comparing the S&P 500 since the beginning of the year, the charts showed that both were rising going into the January peaks. That was bad because the two measures never move the same way for very long. Either the VIX heads back down, or, as happened earlier this year, stocks take a tumble and the VIX spikes.
Sebastian told Cramer that most of the time, when the VIX and the S&P are trading together, the VIX turns out to be right and the S&P turns out to be wrong.
So how about right now? Sebastian notes that over the past month, since June 27, the S&P is up about 130 points, or almost 5%, while the VIX has fallen from 18 to around 12.
Sebastian says that very bullish because it's a sign that traders are not rushing to buy put options to protect against wild swings. In fact, traders are expecting less volatility, not more. For Sebastian that's a sign that big institutional money managers, who use options as insurance, like what they see and believe in the rally.
While disappointing earnings could quickly turn that sentiment around, Sebastian says it's unusual to see the VIX falling sharply heading into the heart of earnings season. After all, dozens of companies reporting financial results can lead to volatility. And the VIX did rise ahead of earnings season in January and April.
With the VIX still falling going into this earnings season, Sebastian views the trend as a positive development, at least on the surface.
But Sebastian told Cramer he is watching the relationship between two other charts closely: the normal Volatility Index and the VIX Volatility Index, or VVIX, which measures the volatility of the VIX itself.
What does Sebastian make of this picture? While the VVIX certainly isn't popping here, the fact that it's still holding near 100 is a sign that VIX traders themselves are still a bit wary. While the Volatility Index has come down dramatically, the VVIX has been pretty steady.
Sebastian says that if the VIX does go below 12 for a few days and the VVIX fails to go back to 90 or even lower, that would be a bad sign because it would imply that volatility will be going back up, and if the VIX does start to rally along with the S&P 500, that's never a good sign.
In short, if the VIX keeps going lower but the VVIX doesn't come down with it, Sebastian thinks you should expect some choppiness in the stock market, maybe yet another painful month of August. But at the moment, both the volatility index and the VVIX are painting a positive picture.
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