Within the equity markets, many individuals look at volatility as a method of gauging anxiety in the market. The idea behind this analysis is that as volatility increases, the value of portfolios fluctuate which increases uncertainty about the future direction of the market. A common tool used for tracking volatility is the Volatility Index or the VIX. Throughout this analysis, I will seek to show you that the fear index can be logically applied to the markets in order to better understand market action.
The concept behind the VIX is that it is supposed to give an investor a concise picture of the emotions within the market. All investors prefer smooth and consistent returns and when volatility changes, these returns can greatly deviate from what investors are familiar with. In order to try and gauge the sentiment in the market, investors typically look at the VIX to see where it has peaked in the past. These peaks or troughs typically occur at market bottoms and occasionally market tops. The chart below shows the popular market anecdote that "emotions are typically the highest when markets turn".
The above chart illustrates the theory nicely by showing when the S&P 500 (SPY) bottomed out after the financial crisis. When volatility reached a smooth but defined peak, the S&P 500 experienced a matching trough which signaled the end of the bear market. The significance of this occurrence is that when investors' emotions were at their highest, the market reached a turning point and ended its ruthless two-year selloff.
This data looks great in hindsight, but does it have any relevance on today's markets? In the current market environment, we have plunging yields, Europe induced-panic, and market wide fear and uncertainty. With such a questionable and uncertain environment, investors surely must be asking themselves if they can trust traditional market indicators such as the Volatility Index. I maintain that volatility works just as well as it has for the past VIX. For the past 26 years, the VIX has been a reliable indicator of market bottoms and like all such calculations, it works best in hindsight. In the below chart, the investor can see the market action for the SPY and VIX for 2012.
As can be seen, fear has recently reached a peak during the months of May and June of 2012. This peak has been followed by a gradually increasing market for the past two months which matches other instances of volatility peaking at market bottoms. At the simplest level, this means that fear is no longer driving the market. Despite what the media headlines and economic reports claim, the market simply isn't behaving as dramatically to fear as it was two months ago. Since fear has peaked, this means that prices could continue their upward march from the 2009 lows.
When attempting to understand where the markets will be in the future, I try and use fundamental financial theory such as the Volatility Index as well as data from another source. As a complement to my fundamental research, I typically will use technical analysis to attempt to find an agreement among both methods. In the below chart, you can see the technical situation in which the SPY currently finds itself. Ever since the lows in June, the SPY has been in a steady up-trending range which has been tested several times but has not been broken. This range represents solid support for the theory that the market has potentially bottomed out and grants an investor the ability to limit risk in his or her endeavors. I believe that if price continues to hold this trend, the theory that the market has bottomed will still be valid. If price falls below the June lows, then I will consider this analysis invalidated and reassess the market conditions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.