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Two contrarian indicators (VIX and S&P 500 share volume) when combined currently offer near-term support for the S&P 500 Index based on historical observations.

Historically, when the Inverse VIXVol Index (see “Caveats” below) moved to minus 10% or greater, as it is now, its subsequent monthly performance was positive (see first graph). The exception to this observation occurred during the fall of ’08 when Lehman filed for bankruptcy and investor panic reigned (see second graph).

Recommendation: Given the current uncertain political, economic and financial global investment environment, large-cap dividend paying stocks should be favored during this phase of the stock market cycle.

The ETF, SPDR S&P Dividend ETF (SDY: 48.29; 6/17/10), offers investors an inexpensive, diversified way to participate in high-quality portfolio of dividend paying companies while participating in the potential near-term support for the S&P 500. SDY’s current indicated quarterly annualized yield is 3.1%.

Summary: There is an inverse relationship between the S&P 500 Index and both the VIX and S&P 500’s traded share volume (“Volume”). When the S&P advances both the VIX and Volume typically decline.

The graph below charts the summations of the percentage change for a 12 week moving average (3 months) for the VIX and Volume inversely plotted against the S&P 500 Index.

As the chart illustrates, there is a visible relationship between the Inverse VIXVol Index and the S&P 500 Index.

An Inverse Relationship: A low VIX-within a range of 20 to 25—indicates a period of rising stock prices which is associated with investors’ perception of less risk. However, a prolonged low VIX (as well as Volume) can be viewed as a bearish signal and a contrarian indicator reflecting investors’ complacency. This condition of investor complacency could represent a prelude to a period of unanticipated greater volatility and stock market weakness.

Pretzel Logic: So, based on the preceding set of facts, one starts out with the proposition that both a lower VIX and Volume would indicate the conditions of a rising stock market. However, at some point in time this proposition becomes a contrarian indicator—signifying a pending slip in the S&P 500 Index.

Say When? Therefore the threshold question is: At what point does this constructive relationship become a contra indicator?

There were 5 occurrences when the Inverse VIXVol exceeded 6% since 2000. Of the 5 times, 4 were subsequently followed by a monthly decline in the S&P 500; this decline averaged 5.6%. (The only incident of the market subsequently increasing when the VIXVol Index exceeded 6% occurred in December of ’01.)

Current Basis of Support: Both the VIX share Volume has been highly volatile this year. The VIX has experienced some very large percentage changes on a weekly basis—particularly on the upside.

When inverted and smoothed on a 12 week moving average, it has the effect of keeping the moving average lower. To a large extent, this is the reason the percentage change in the Inverse VIXVol Index recently appeared to have moved much lower than the related change in the S&P.

Signaling Support: Historically, when the Inverse VIXVol Index moved to a minus 10% or greater, as it is now, the subsequent monthly performance was positive.

Exception to the Rule: The exception to this observation occurred during the fall of ’08 when Lehman filed for bankruptcy. The VIX went “through the roof” registering over 80 while daily Volume spiked to 11 billion shares.

However, even in the case of the ’08 series, the last two “ticks” below a minus 10% generated higher stock price in the subsequent month. So, this appears to be a fairly durable series. (See graph below)

Caveats: The Inverse VIXVol Index is not a recognized technical index but two series (VIX and S&P share volume) placed together as a result of their logical inverse relationship with the S&P 500. Its construction may be flawed on further review.

No single indicator should be relied upon exclusively. Other quantitative and qualitative tools should be employed to corroborate results prior to making an investment decision.

(Additionally, declining swap spreads provide additional support to this general thesis. See: Declining Swap Spreads Are Very Bullish (6/15/10), authored by Calafia Beach Pundit.)

Disclosure: Author is long SDY

Source: SDY: Contrarian Indicators Offer Near-Term Support for S&P 500