How the VIX Has Historically Forecast Stock Prices

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 |  Includes: DIA, QQQ, SDS, SPY, VXX
by: Brett Owens

There's still not much of an appetite to buy stocks - but volume remains very quiet as the dog days of summer wind down.

We've been expecting a decline in stocks, and have been watching for slowly rising volume to accompany these declines to give us a heads up that there is some "umph" behind the selling. So far we've seen price action cooperate, but not (at least yet) volume. Though with August winding down, we may not see significant buying or selling conviction until after Labor Day.

The VIX was up quite a bit, though, yesterday - nearly 10%. Since spiking in May, the widely watched "fear index" has calmed down a bit (click to enlarge images):

Volatility VIX VXX Price Chart September 2010

Since spiking in May, the VIX has cooled off - though it has remained well above its March/April lows.

(Source: StockCharts.com)

Some investors and money managers are currently playing the VIX from the long side, as a hedge against a potential downturn. This intuitively makes sense - though when you look at the price history of the VIX over the last 36 months, it appears that making money from the long side would have been quite challenging:

Volatility VIX VXX Price Chart September 2008 2009 2010

The VIX since the credit crisis began in late summer '07.

(Source:StockCharts.com)

Looking at a chart like this, the only way I can think to trade it would be to buy some out-of-the-money call options in anticipation of a mega-spike. Going long straight-up looks like a whipsaw nightmare.

It's interesting that the VIX actually topped in October of 2008 - about five months before the eventual stock market bottom in March of 2009.

Turning the telescope around, we can see that initial "higher highs" in the VIX were signals in late '07 to early '08 that you may want to dump your stocks and head for the hills. But then the VIX laid quiet until the end of summer - during a time when the stock market continued to descend, albeit slowly - only to breakout in September in epic fashion (as the stock market broke down, also epically), leaving no prisoners in its wake.

Many market observers are predicting a similar breakout for the VIX this September/October - which makes perfect sense. Except for the bothersome point that EVERYONE is waiting for this to happen. We'll soon see if the Mr. Market cooperates with an instant replay of Fall 2008...or if he's got another trick up his sleeve!

Disclosure: Author is short the S&P 500 (via SDS) and the euro