Stock Market Drop May Be in the Cards

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( TheGoldAndOilGuy.com) -- Over the past five months we have seen volatility steadily decline as stocks and commodities rise in value.

The volatility index is now trading at a level that has preceded many selloffs in the stock market over the years as investors become more and more comfortable and greedy with rising stock prices.

Seeing everyone running to buy more stocks for their portfolio has me on edge. We could see a strong wave of fear/selling hit the S&P 500 index over the next two weeks, catching the masses with their hand in the cookie jar ... again.

If you don't know what the CBOE's volatility index (VIX) is, then think of it as the fear index. It tells us how fearful/uncertain investors are or how complacent they are with rising stock prices. Additionally a rising VIX also demonstrates how certain the herd is that higher prices should continue.

The chart below shows this fear index on top with the S&P 500 index below and the correlation between the two underlying assets. Just remember the phrase, "When the VIX is low it's time to go, When the VIX is high it's time to buy."

Additionally the volatility index prices in fear for the next 30 days, so don't look at this for big-picture analysis. Fear happens very quickly and turns on a dime, so it should only be used for short-term trading, generally three to 15 days.

Volatility Index and S&P 500 Correlation and Forecast Daily Chart

Global Issues Continue to Grow but What Will Spark Global Fear?

Everyone has to admit the stock market has been on fire since the October 2011 lows. The S&P 500 index is up more than 26% since then. It has been a great run, but is it about to end? Where should investors focus on putting their money? Dividend stocks, bonds, gold or just cash?

I may be able to help you figure that out.

Below is a chart of the volatility index and SPDR Gold Shares ( SPDR) the gold exchange-traded fund, which tracks the price of gold bullion. Notice that when fear is just starting to ramp up, gold tends to be neutral or a little weak. But soon after investors start selling their shares of securities, we see money flow into the shiny yellow safe haven.

Gold and Fear Go Hand in Hand

Looking at the relationship between investor fear/uncertainty and gold, you will notice scared money has a tendency to move out of stocks and into safe havens.

Trading Conclusion Looking Forward Three Months

In short, I feel the financial markets overall (stocks, commodities and currencies) are going to start seeing a rise in volatility, which means larger daily swings. This inherently increases overall downside risk to portfolios and all open positions.

To give you a really basic example of how risk increases, look at the daily potential risk the S&P 500 can have during different VIX price levels:

Volatility index under 20.00: Low Risk. Expect up to 1% price gaps at 9:30 a.m. EST, and up to 5% corrections from a previous high.

Volatility index between 20.00 and 30.00: Medium Risk. Expect up to 2% price gaps at 9:30 a.m. EST, and up to 15% corrections from recent market tops or bottoms.

Volatility index over 30.00: High Risk. Expect 3%-plus price gaps at 9:30 a.m. EST, and possibly another 5%-15% correction from the previous VIX reading at Medium Risk.

Note on price gaps: If you don't know what I am talking about, a price gap is simply the difference between the previous day's close at 4:00 p.m. EST and the opening price at 9:30 a.m. EST.

To continue on my market outlook, I feel the stock market will trade sideways or possibly grind higher for the next one to two weeks. During this time, volatility should trade flat or slightly higher because it is already trading at a historically low level. It is just a matter of time before some bad news hits the market or sellers start to apply pressure. Either of these will send the fear index higher.

I hope you found this information useful. If you would like to get these reports free every week, be sure to subscribe to my free newsletter here at GoldAndOilGuy.com

This commentary comes from an independent investor or market observer as part of TheStreet guest contributor program. The views expressed are those of the author and do not necessarily represent the views of TheStreet or its management.

Chris Vermeulen is founder of the popular trading sites www.thegoldandoilguy.com and www.ActiveTradingPartners.com. There he shares his highly successful, low-risk trading method. Since 2001, Chris has been a leader in teaching others to skillfully trade in gold, silver, oil and stocks in both bull and bear markets.

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