Thursday, November 20, 2008

VIX Volatility over 30 = BEAR MARKET

To me, the CBOE's volatility index for the S & P 500 is a primary indicator for my allocations to stocks, bonds and cash. It dawned on me some time ago that a high level for the VIX is inconsistent with a bull market. By high, I mean readings over 30. A reading around 25 is worrisome for a bull and very troubling coming out of long stable bull market VIX pattern of 10 to 20. 

If the S & P 500 goes down a lot like today, the VIX will go up. It would be unusual for the VIX and the market to both go in the same direction on a significant daily move for the S & P 500. Some say that the extreme level of the VIX simply means that the market will be moving both up and down a lot, extreme moves in both directions, and that is undoubtedly true. It would not surprise me to see another 900 point up day following by two 500 point down days sometime later this month. The point that I am making is different. A bull market itself is dependent on low and stable levels of volatility. By low, I mean less than 20. People have to have confidence, feel comfortable and secure about the future, fat and happy, with few worries by most investors except for those who worry all of the time about everything. Simply put, extreme and consistently high volatility is the essence of a bear market and stable and low volatility is the essence of a bull market. To avoid a false signal, I would generally require three months of the VIX below 20 to indicate the start of a new bull market. This may change in the future but it has worked in the past, perfectly.

Models always are in need of modification to adjust to changes in circumstances. For example, I have never seen the VIX zoom over 40, 50, 60 and 70 and I have been struggling to identify what it means, other than trouble. Previously, during an unstable VIX period, where it is swinging wildly up and down, I would consider buying the double long S & P 500 ETF (SSO) on a spike to 35; sell it when the VIX falls back to, or no more than 2 points below, 20; then buy the double short S & P 500 (SDS) when the VIX falls to 18 and lastly sell the SDS when the VIX returned to the mid 30 level. I call this my swing trade developed by an old gamer. That was fine until a few weeks ago when the VIX just kept going like some EverReady battery flying past 40 on its way to 80. Fortunately I got off the swing trade train, missing the buy SDS part of it as I discussed earlier since the VIX did not fall to below 18.Sometimes a Trading Mentality Can Trip Me UP  & see 4th paragraph in this post: Buy High & Sell Low /Retrospective on the Good & Bad  I was being a stickler for the details of my trading system for this swing. I would have made money on that trade for a while, but then the model would have had me selling SDS when the VIX hit 35, or close to it, and buying the SSO which would have been a failed trade. The SDS, last sold at over 70, is now at 128, and this would not be a good time to be holding a double long S & P 500 ETF to say the least. So I made good money on my double short buys and sales this year, missed the last SDS trade and consequently avoided the mistake of buying SSO to complete the swing. The model has to be refined. How? Well, it would give more leniency on buying the SDS during this volatile VIX period, below 20 will suffice for at least 1/2 of the trade, and there will need to be a mental stop loss on the SSO when and if the VIX crashes over 40.

While it was not abnormal for the Nasdaq volatility index to go to 70, which it did doing the last meltdown in that average, it was highly unusual for the S & P VIX to go to 40, let alone 80. So, we are in uncharted territory and I need to adjust my thinking about what this means. My working theory is that it means that this will be a very nasty bear market that is not close to being done yet and may actually be entering a new phase. I was looking a few minutes ago at a long term chart of the S & P 500 and I think that it would cause a technician heartburn. It has the appearance of double top formation that has broken to the downside, with the next major support area being around 400 to 450, which would take us back to the period between 1992 to around April 1994. I am listening mostly to my volatility models but I do consult charts and my reading of the long term S & P chart confirms my wariness now of where we may be heading over the course of the next several months. Fundamentally, I think that this market is way oversold but I am going to adhere to what has worked for me and stay away for now as I mentioned in an earlier post. At a minimum, it will take several years to repair the damage that has been done over the past few weeks. My current estimate is 3 to 5 years.

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