Is the Volatility Index Warning Us About the Stock Market?
Friday, August 24th, 2012
By Sasha Cekerevac, BA for Profit Confidential
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.