A Dark Cloud In Sunny Market Skies

by: Eric Parnell, CFA


The stock market skies are filled with abundant sunshine.  Pullbacks are measured not in months or weeks, but in hours and minutes.

Yet a notable dark cloud continues to accumulate in these otherwise sunny market skies.

Is it possible that a storm has been slowly building for some time now despite the steadily increasing climb of the U.S. stock market?

The U.S. stock market remains relentless. It seems to rise strongly day after day without interruption. Pullbacks to the downside are no longer experienced over the course of months, weeks or even days, but instead can best be measured in terms of hours if not minutes as each and every pullback is snapped up almost unflinchingly by today’s risk eager marketplace. Indeed, the sun shines brightly on today’s U.S. stock market. But for those that have yet to completely abdicate from managing against downside risk, a dark cloud in an otherwise sunny sky for stocks is worth noting.

Puttin’ On The VIX

The stock market may very well never go down again. But given that I’m not yet inclined to relent to the notion that “this time is different”, it remains worthwhile to continue to consider the reasons why it might still actually go down, potentially for a period of time lasting longer than a few days, going forward.

And an indicator that has been sending a signal for quite some time now that a pullback in the market may be looming ever closer is hanging increasingly heavy in the skies. This indicator comes from the CBOE Volatility Index, more commonly known as the VIX, which is a measure of expectations about future price volatility in the S&P 500 Index (SPY) over the coming 30 days. It is constructed by measuring the implied volatility of S&P 500 Index (IVV) options.

While the relationship between the S&P 500 Index (VOO) and the VIX is largely well known, it is worthwhile to demonstrate the coincident nature of this inverse relationship. Put simply, when the S&P 500 Index rises, the VIX almost always falls. And when the S&P 500 Index tumbles into correction, the VIX almost always spikes to the upside. This relationship is reflected in the following chart below.

In short, the VIX is an outstanding diversifier for a stock portfolio. Unfortunately, securities markets largely lack a clean and simple security that effectively tracks the VIX over time without a considerable amount of leakage (loss in value) along the way. Moreover, another shortcoming of the VIX is that it is a coincident indicator, as it typically does not start spiking higher until the decline in stock prices is simultaneously upon us.

This does not mean that the VIX is still not useful as a predictive tool for the U.S. stock market, however. As first highlighted in an article on Seeking Alpha in mid 2017, tracking the volatility of the VIX has proven a fairly reliable tool in working to anticipate the building of stock market corrections in advance of the pullback finally taking place.

You VVIXen

The CBOE VIX of VIX Index, or VVIX, is a measure of volatility (VXX) of the VIX itself. And just like the slow accumulation of clouds that eventually culminates in a violent thunderstorm, the volatility (VXZ) of the VIX itself has typically risen in advance for weeks if not months in advance of a sustained spike in the VIX itself.

But isn’t the VIX already on the rise? After all, it has been climbing higher since the start of the 2018 calendar year – it has spiked a hearty +27% higher since January 3 despite the fact that the S&P 500 Index has risen on a total return basis by nearly +5% over this same time period – it remains locked in a steady downtrend and its rise has been largely dismissed as investors simply recognizing that options have become so cheap that they can be used to help further enhance stock portfolios in their continued move to the upside.

None of this sounds like much of a cloud. Even with the VIX moving sharply higher, stocks are still gaining. The sun shines bright and stocks continue to rise higher each and every day. Trade on, my friends!

Perhaps. But then again, this recent move higher in the VIX, albeit from record low levels, may be the latest cloud to form in the sky as an increasingly accumulating storm starts to slowly roll in.

To this point, consider the volatility (VIXY) of the VVIX over the past many months now. While the VIX remains in a downtrend, the VVIX has been steadily increasing since last July.

Past Thunderstorms

Of course, the VIX is already a volatile reading filled with a lot of noise, so the volatility of the VIX is even more so volatile. So in order to get a better reading to see if the VVIX is telling us anything meaningful, it is worthwhile to consider its 90-day moving average, which helps to smooth out the daily noise and provide a better indicator of intermediate-term to long-term trend. And viewing the VVIX through this lense reveals information that has proven useful in predicting stock market pullbacks and corrections in advance.

Consider the following points from the chart above.

1 – On 6/3/08, the 90-day moving average of the VVIX (adjusted VVIX) bottoms and starts to steadily rise. On 8/22/08, the VIX itself starts to rise along with the S&P 500 Index starting to fall into correction. Over the next three months, the S&P 500 Index falls by more than -40% while the VIX quaduples.

2 – On 1/9/10, the adjusted VVIX bottoms and starts to steadily rise. On 4/20/10 the VIX itself finally bottoms after drifting steadily lower throughout the early spring. Just a couple of trading days later, the S&P 500 Index peaks before flash crashing in May and falling into the summer.

3 – On 1/27/11, the adjusted VVIX bottoms and starts to steadily rise. The S&P 500 Index proceeds to go through a head and shoulders topping pattern through the winter and spring before finally breaking to the downside in mid-July 2011 and falling nearly -20%. The VIX itself did not start moving higher until almost the same exact moment that the S&P 500 Index itself started falling in July.

4 – On 3/29/12, the adjusted VVIX starts to turn back higher. The S&P 500 Index turns sideways before reaching its final peak and turning lower starting in early May 2012.

5 – On 3/28/13, the adjusted VVIX bottoms and starts to steadily rise. A few weeks later, the U.S. stock market starts to fall and interest rates rise amid the so called “taper tantrum” in May and June 2013.

6 – On 7/23/14, the adjusted VVIX bottoms and starts to steadily rise. The S&P 500 Index briefly corrects not long after, but subsequently rallies to new highs by September 2014. U.S. stocks proceed to fall by more than -10% over the next month before St. Louis Fed President James Bullard saves the stock market day with hints of further monetary support ahead.

7 – On 6/25/15, the adjusted VVIX bottoms and starts to steadily rise. The S&P 500 Index continues to trade near all-time highs through early August 2015 before suddenly plunging to the downside. Stocks thrash back and forth for several months, falling by as much as -15% from peak to trough along the way.

8 – On 6/7/16, the adjusted VVIX bottoms and starts to steadily rise. The S&P 500 Index manages to overcome the jitters associated with Brexit but eventually peak a few weeks later in early August before correcting by just over -5% through early November.

On eight different occasions since the outbreak of the financial crisis more than a decade ago now, the 90-day moving average of the CBOE Volatility of Volatility Index reached a notable inflection point and reversed in advance of the stock market by nearly three months on average and as much as six month or more in advance of what turned out to be notable peak inflection points for the U.S. stock market.

False positives? Over the past decade, the VVIX has provided a couple of false positives in anticipating trough bottoms. But it remains undefeated over this same time period in anticipating peak inflection points. Put simply, it has proven itself to be a useful and reliable tool in anticipating short-term stock market peaks particularly since the calming of the financial crisis.

Umbrella Anyone?

So where does the VVIX stand today on a 90-day moving average basis? It bottomed last June and has been steadily on the rise ever since. As a result, it has been climbing higher for seven months and counting. Yet at the same time, stocks continue to increase to new all-time highs and the VIX continues to trend toward new lows.

Perhaps this recent divergence is nothing to worry about. Perhaps this will be the false positive exception. This is very possible, as the post crisis period has been all about traditional rules and established patterns being repeatedly broken. Perhaps this time it will be the VVIX falling back to earth.

But then again, perhaps it is something to worry about. Perhaps the rising VVIX continues to herald trouble that still lies ahead for the U.S. stock market. Perhaps it will be the S&P 500 Index falling and the VIX rising to match the trend first suggested by the VVIX.

Only time will tell. But it must still be recognized that this notable divergence exists, and it will eventually need to resolve itself in one way (VVIX falling) or another (stocks falling). And if the precedent of the last eight instances is repeated for a ninth time in the coming weeks or months, it will be the more cyclical and momentum driven higher beta sectors that have been running so hot to the upside lately that are most likely to get hit equally hard to the downside.

The stock market skies remain sunny. Bask in the warmth, but also do not overlook the looming clouds in the sky. For just as investors eventually learned in 1987, 2000 and 2007, sunny skies do not last forever no matter how incredible the market weather may seem at any moment in time.

Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners will be met.

Disclosure: I am/we are long RSP,SPLV.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.