Is the Volatility Index Warning Us About the Stock Market?
By Sasha Cekerevac, BA•Friday, August 24, 2012
While the economic data have continued to come in worse, the S&P 500 has strengthened over the past few months. What is the stock analysis that can justify such a move, and is it sustainable? These two questions are critical for those interested in investing in stocks. There are several reasons for why the S&P 500 is at current levels, and it starts with how stock analysis is conducted.
The first thing to remember when investing in stocks is that the market is a forward-looking mechanism. That means that the current economic environment is not as important as what will happen 6–12 months or more into the future. Proper stock analysis needs to take this into account and try to understand where the winds will be shifting.
Another way to conduct stock analysis is to take a look at the Volatility Index (VIX). The VIX is a gauge of how much volatility there is in the market. Generally speaking, when the volatility is low, stocks are moving up in a slow fashion, while spikes in volatility coincide with market crashes.
Chart courtesy of www.StockCharts.com.
This chart shows the S&P 500 overlaid with the VIX over a three-year weekly view. What basic stock analysis will tell you is that periods of low volatility have been quickly met with violent moves down in the market. Investing in stocks is difficult enough as it is, but this chart clearly shows that when the market is at its most quiet, that’s when investors should be alert to the possibility of a pullback.
Many people interested in investing in stocks will point to world central bank activity. With more people believing in their stock analysis that world central bankers will be adding monetary stimulus before the end of the year, they feel “safer” investing in stocks at the current moment. Personally, I think that when everyone believes one idea, one should look at the possibility that the majority of people might be wrong in their stock analysis.
Investing in stocks actually is most profitable when volatility and fear are at their highest. Looking at this chart, whenever the VIX is shooting up, stocks are crashing and fear is rising. The reason why most people who are interested in investing in stocks lose money is that they do the opposite; they buy when they think it’s the safest. Stock analysis is not that easy; if it was, everyone would be rich. Obviously, that’s not the case.
The real concern is what happens when the additional monetary stimulus is added. There’s a good chance that the market might be poised for a “buy on the rumor, sell on the fact” reaction. Stock analysis is difficult to begin with. Having gone through so many rounds of monetary stimulus already, and with so little effect, the market might be worried that there won’t be any positive reaction.
Investing in stocks is all about trying to figure out what is most likely to happen in the future. If this next round of monetary stimulus fails to kick-start the world economy, we could be in for a very big selloff. Time will tell, but I would be cautious with my stock analysis. If the market breaks below key technical levels, I’d head to the sidelines and protect my capital, waiting to buy shares when my stock analysis shows that they’ve become unreasonably cheap and fear is sky-high.
Is the Volatility Index Warning Us About the Stock Market? was last modified: September 5th, 2012 by Sasha Cekerevac, BA
Sasha Cekerevac, BA Economics with Finance specialization, is a Senior Editor at Lombardi Financial. He worked for CIBC World Markets for several years before moving to a top hedge fund, with assets under management of over $1.0 billion. He has comprehensive knowledge of institutional money flow; how the big funds analyze and execute their trades in the market. With a thorough understanding of both fundamental and technical subjects, Sasha offers a roadmap into how the markets really function and what... Read Full Bio »
Forecasts Aug. 30, 2015
Immediate term outlook:
The bear market rally in stocks that started in March 2009, extended because of unprecedented central bank money printing, is coming to an end. Gold bullion is up $1,000 an ounce since we first recommended it in 2002 and we are still bullish on the physical metal.
Short-to-medium term outlook:
World economies are entering their slowest growth period since 2009. The Chinese economy grew last year at its slowest pace in 24 years. Japan is in recession. The eurozone is in depression. With almost half the S&P 500 companies deriving revenue outside the U.S., slower world economic growth will negatively impact revenue and earnings growth of American companies. Domestically, America’s gross domestic product grew by only a meager 2.3% in the second quarter, which will negatively impact an already overpriced equity market.
Estimates Aug. 30, 2015
Trailing 12-month EPS for Dow Jones companies (Most Recent Quarter)