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The Great (VIX) Debate

 

 

Daily State of the Markets
Thursday Morning - March 15, 2012

Good Morning. Obviously the bears are more than a little frustrated these days. And you can't really blame them. Since it became obvious to just about all market players that the sky was indeed falling last November, the S&P has gained nearly 21%, the DJIA has romped to its highest levels since 2008, and don't look now, but the NASDAQ on Tuesday broke through one of those big, round numbers, and a level not seen since... wait for it... December 2000. So, despite all of the prognostications for gloom and doom by the brightest minds on Wall Street, the bears have been proven dead wrong over the past sixteen weeks.

However, the glass-is-half-empty crowd tends to be ever optimistic in their pessimism. In fact, despite the bulls' recent joyride to the upside, the bear camp is now touting a new reason to be bearish right about now - the VIX. You see, the so-called "fear index" broke below 15 on Tuesday and according to our furry friends, this is a sure-fire signal that stocks are about to take a dive.

While I've never been much of a fan of watching the VIX for assistance in identifying what the market is doing (in my humble opinion, the movement in the VIX a little like somebody announcing that Peyton Manning is a pretty good football player), there is a decent debate going on in the fast-money circles about the VIX breaking below the seemingly magical 15 level.

If you have a moment, take a peek at daily chart of the VIX (volatility index) over the past year. You will likely be struck with the obvious realization that, hey - this thing is pretty low. And if you lengthen out your chart a bit, you will see that the VIX tends to bounce higher when it reaches the magical 15 level. And in case you don't pay attention to this stuff, when the VIX is rising, stocks are usually falling.

This argument is abundantly clear if you switch to a weekly chart of the VIX. As the chart below indicates, the 15-level does indeed appear to be a magical signal that things are about to change - and not in a good way for stock prices!

In fact, a colleague of mine called yesterday afternoon and suggested that longer-term investors may want to allocate a portion of their portfolio to a strategy of buying the VXX (Ipath S.T. VIX ETF) or the VXZ (Ipath Mid-Term VIX ETF) whenever the VIX broke below 15. My friend noted that if you had a long enough time horizon, gains of 30% - 35% usually ensued on the trade. It might take a while for the trade to come to fruition, but his argument was simple: periodic gains of 35% can really add up.

However, before you go and start buying the VXX or the VXZ on margin, there is another side of this debate that needs to be considered. You see, the period being used by the bear camp for their argument (last 5 years-ish), was clearly a bearish environment. But when you look back to a more positive environment, the picture is completely different.

The graph below shows the VIX during the 2004 - 2007 period, which up until mid-2007 was a bullish cycle for the stock market. And as you can readily see by the chart, the 15-level (the thick horizontal line drawn on the chart) wasn't a buy point during this environment. No, it was a reading in the vicinity of 10 that generally got the bears fired up.

My point is that while a reading below 15 on the VIX has been a sell signal for stocks over the past 4-5 years, the index can go a lot lower during bullish phases in the market. (A similar picture can be seen if you go back to bullish phase seen the mid-1990's.)

Yes, it is true that stocks are now overbought and due for a pullback. And as such, yes, the 15-level may once again be an indication that stocks may be ready to pull back. But before you bet a lot of money on this idea, make sure you understand that indicators act differently in different market environments. Again, I'm not saying the bears are wrong. I'm merely saying that this indicator hasn't spot on during bullish phases of the market. Thus, the key question is if this market has entered a bullish phase or remains a bear. Stay tuned.

Turning to this morning... Stock futures are slightly above fair value in the early going as overseas markets were mixed and traders are awaiting a boatload of economic data.

On the Economic front... Initial Claims for Unemployment Insurance for the week ending 3/10 fell 14,000 to 351K which was below the consensus estimate for 357K and below last week's revised total of 365k (from 362k). Continuing Claims for the week ending 3/3 came in at 3.343M vs. consensus of 3.413M.

Next up, the Empire Manufacturing Index (designed to indicate the state of the manufacturing sector in the New York region) for March was reported at 20.1, which was well above the consensus expectations for a reading of 16.8 and also above last month's reading of 19.53.

On the inflation front, the Labor Department reported the Producer Price Index for February rose by +0.4%, which was below the consensus estimate for a rise of +0.5%. When you strip out food and energy, the so-called Core PPI came in at +0.2%, which was in line with the consensus for +0.2% but below last month's +0.4%.

Finally, we will get the Philly Fed Index at 10:00 am eastern.

Thought for the day... "Inflation is taxation without legislation" -- Milton Friedman

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

  • Major Foreign Markets:
    • Australia: -0.20%
    • Shanghai: -0.73%
    • Hong Kong: +0.21%
    • Japan: +0.72%
    • France: -0.01%
    • Germany: +0.21%
    • Italy: +0.03%
    • Spain: +0.02%
    • London: -0.11%
  • Crude Oil Futures: +$0.30 to $105.73
  • Gold: +$2.40 to $1645.30
  • Dollar: lower against the euro, higher vs. yen and pound
  • 10-Year Bond Yield: Currently trading at 2.317%
  • Stock Futures Ahead of Open in U.S. (relative to fair value):
    • S&P 500: +3.32
    • Dow Jones Industrial Average: +29
    • NASDAQ Composite: +7.8

Positions in stocks mentioned: None

For more of Mr. Moenning's thoughts and research, visit StateoftheMarkets.com


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Disclosure: I am long VXZ.