Volatility Spikes as Indicator of Market Capitulation

With the VIX spiking over 30 this morning and investors wondering if the markets will ever find a bottom, this seems like a good time to talk about VIX spikes and market bottoms. Specifically, I want to dispel the myth that bear markets have to end in some grand capitulation climax that includes a dramatic volatility spike.

A perfect counter example to the VIX spike requirement can be found in the bear market that followed the NASDAQ boom which crested in March 2000. In fact, with the exception of the current bear market, the 2000-2002 bear market is the only bear market since the launch of the VIX back in 1993 or the historical reconstruction of VIX data by the CBOE that dates back to 1990.

Rather than use the SPX and the VIX to demonstrate my point, the chart below uses the NASDAQ-100 index [NDX] and its companion volatility index, the VXN. The reason I chose the NDX is that from the March 24, 2000 peak (4816.35) to the October 8, 2002 bottom (795.25), the NDX lost an astonishing 83.5% of its value. If there was ever an opportunity to witness a dramatic drop and capitulation, this was the market and index in which to see it happen.

If one looks at a chart of the NDX and the VXN for the period 2000-2002, five distinct VXN spikes stand out. I have highlighted these with a blue vertical line for easy reference in the chart below. It turns out that those who went long at the time of these volatility spikes saw anywhere from two weeks of a bounce to several months of mostly sideways action. None of these spikes signaled a lasting market bottom.

When the NDX finally hit bottom (marked by the red vertical line and arrow), the VXN barely moved at all. Yes, the nastiest bear market of the last two decades ended with a volatility whimper.

Capitulation comes in all shapes in sizes. Most bottoms are marked by a VIX spike. If, however, you assume that volatility spikes will mark the bottoms and bottoms cannot form without a VIX spike, you will be overlooking an important lesson from perhaps the most important recent bear market.

Click to enlarge:

Comments

[Dan Walker:]

You have an excellent point, but with a nod to ewave theory, I have to wonder historically how much you risk by buying the 5th volatility spike? At this point it is more of an academic than strategy question, but it is something I will kick around.

2008 Sep 16 06:53 AM

[Dan Walker:]

Excellent point. However, it does prompt me to wonder, with a nod to ewave theory, how risky historically it would be to buy the 5th volatility spike? At this point it is more of an academic than a strategy question, but one I will ponder.

2008 Sep 16 07:07 AM

[ain't no fo...:]

The constant in this sucking chest wound bear has been interim volatility spikes that have taken the market to successive lows every few months. It is characterized by VIX and VXN spikes, and high bearishness figures in other indicators, which precipitates sharp, violent short covering rallies.

In this way, the longs get hurt on the way down, and the shorts get squeezed just as they really start piling on. It is the mark of this bear to rob from Peter AND Paul.

Each successive low makes the intermediate and longer term technicals look worse, and we are now on the verge of breaking significant multi year support levels on all the major indices.

Yet no doubt this latest round of volatility will suck in longs and shorts alike, and only the nimble and skeptical on both sides of the trade will avoid more debilitating losses.

2008 Sep 16 09:11 AM

[skyflyz:]

Excellent analysis.. it seems to me that over time, the fear factor of a repetitive downward trend seems to abate, therefore, by the time of the actual market bottom, investors have, more or less, gotten used to market going down, thus no large spike in volatility. However, a short term trader can take advantage of the vix spikes - as you pointed out, there is at least a short-term upward movement after each one.

2008 Sep 16 05:20 PM

[Steven Hansen:]

i realize the market is not logical but really it is overpriced still (P/E) and the economic outlook very unclear.

why would there be a rally?

2008 Sep 16 09:15 PM