Money & Finance - Near-term Market Weakness

The Volatility Index (VIX)

The volatility indices measure the implied volatility for a basket of put and call options related to a specific index or ETF. The most popular is the CBOE Volatility Index (VIX), which measures the implied volatility for a basket of out-of-the-money put and call options for the S&P 500. Specifically, the VIX is designed to measure the expected 30-day volatility for the S&P 500.

 

Market Volatility Correlation

Back in December, we published a note (Money and Finance 12/19/11) on the breakdown in the inverted correlated relative volatility between the Volatility Index (VIX) and the S&P 500 (SPX). By examining these trends, we noted the obvious trepidation of market participants, but noted that we were at levels that preceded a market rebound.

After taking our more aggressive bullish stance towards the end of last year, we have been able to capitalize on a strong move higher from the start of the year.

Looking back to the end of March this year, we received completely different reading from the same VIX model indicating it was time to step away from the market. In figure 1, the gray line represents the correlation between VIX / SPX volatility. One can see that when this inverse correlation improves (falls further from zero), as it had in late March 2011, the stock market headed lower.

Given that this correlation is one of the metrics in our behavioral model, it prompted us to start taking profits and start to look for a potential pullback in the markets. This kept us out of the turbulent markets of April and May 2012.

Bottom Line: The model has started to head back to zero once again and that is a red flag for us to be cautious regarding future stock market returns. We have continued to de-lever and take profits into market strength. We are expecting a near-term pull-back (albeit a minor one) before the end of the year.

 

JSK VIX Analysis

When analyzing our proprietary VIX model, one can see that we have entered the “Extreme Euphoria” zone. Looking back historically, when our VIX model enters this zone, we have experienced weak and negative stock market results.

Bottom Line: This is further evidence that taking profits and correction preparation is the most prudent investment action at this time.

 

 

Market Complacency

There has been an extreme case of complacency that has set into the market.

When looking back at the historical VIX over the past few years, it seems the $15 level is the point of complacency that usually precedes a market drop.

Figure 5 and 6 show the correlation between the VIX and the S&P 500.

Bottom Line: We have taken significant profits for the third quarter of the year and are now looking for a near-term correction in the market. While our long-term outlook remains bullish, our shorter-term outlook is bearish and we are preparing for a market correction.

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