Why a low VIX does not mean the S&P 500 will fall


VIX is collapsing right now. After a small spike in April 2017 while stocks fell, VIX has fallen just below 10 while stocks are rising. The first chart is a 1 year daily bar chart for VIX, while the 2nd chart is the all-time monthly bar chart for VIX (VIX was created in 1990).


A lot of investors are freaking out about VIX. “VIX is too low! VIX is near its all-time historic lows! VIX is going to spike soon! The S&P 500 is going to crash!” History shows that this is simply not true.
*VIX is the volatility index. It is the market’s implied 30 day volatility for a range of options. When VIX is low, investors are “complacent” and are bullish on the U.S. stock market. When VIX is spiking, investors are fearful. VIX is typically used as a contrarian indicator. When VIX is low (the masses are bullish), savvy investors say that stocks will fall and VIX will rise in the near future. When VIX is spiking (the masses are fearful), savvy investors say stocks will rise and VIX will fall very soon.

What happens historically when VIX is low

Let’s look at 2 cases.

  1. VIX is just above 10 right now. Let’s see what happens when historically, VIX first fell to 10.
  2. Let’s see what happens when VIX hits a multi-year bottom (i.e. fell below 10). Some pessimists say that if VIX continues to fall below 10 over the next few weeks, a big selloff in the S&P 500 will follow.

We want to see what happens to the S&P after these 2 cases play out. Does the S&P 500 make a small correction, a significant correction, or a bear market very soon?
What happens when VIX falls to 10
It is very common for VIX to fall to 10 during a rally within a bull market. This first happened in:

  1. September 3, 1992. Then VIX spiked to 20 by early-October 1992 while the S&P made a small 3.4% pullback. Then VIX pretty much bounced above 10 until December 1995. This meant the VIX remained just above 10 for more than 2 years.
  2. February 4, 2005. Then VIX rose to more than 18 by mid-April 2005 while the S&P 500 made a small 6.7% correction. Then VIX fell and consolidated above 10 for 2 years before starting to rise in February 2007.
  3. June 6, 2014. VIX continued to remain flat until the S&P made a 9.9% correction from mid-September to mid-October 2014. Since then VIX has pretty much hovered above 10, despite the occasional spike.

As you can see, VIX usually hovers just above 10 for years before it permanently starts to rise. However, the S&P will only enter into a bear market after VIX has been rising for months (in 2007’s case) or years (in 1995’s case).
VIX has remained around 10 for almost 3 years. Perhaps VIX will start to permanently rise above 10 soon. This does not mean that a bear market in stocks will ensue.
What happens when VIX falls below 10.
VIX fell to a low of 9.9 on May 1, 2017. Bearish investors fear that this will trigger a correction. Let’s see what history says. Let’s see what happens when VIX first falls below 10 after an extended period of time.

  1. July 12, 1993. The S&P completely ignored VIX. The S&P kept going up until late-January 1994.
  2. July 20, 2005. Then the S&P made a small 6.1% correction from late-July to mid-October 2005.
  3. November 20, 2006. The S&P completely ignored VIX. It rallied vigorously all the way until late-February 2007.

Bottomline
There are 2 things to take away from this study:

  1. Sometimes the S&P will make a pullback/correction very soon after VIX gets to 10. Sometimes the S&P will rally for months despite a very low VIX. So VIX is a terrible timing indicator for the S&P’s corrections.
  2. VIX can be low for a very long time before it spikes and the S&P crashes.

So perhaps the S&P will make a small correction right now. Perhaps it will make a small correction this summer like bond king Jeff Gundlach said. We think that the odds for both cases are 50-50 (i.e. not worth betting on). But if a correction does occur, it will not do so because VIX is low. VIX is a poor timing indicator.
And even if the S&P does make a correction, the correction will probably be a small one. Our model states that the S&P will not make a big correction any time soon. (Keep in mind that our model updates every day, so perhaps the situation will change as time goes on. We’ll see).

Why we do not use VIX in our model

We don’t use VIX in our model because it has two problems: one big and one small.
Big problem with VIX
VIX’s history simply does not go far back enough. It started in 1990. You cannot use an indicator that does not have enough data or history. This is the mistake that many failed hedge funds and investors make. They say “this indicator has a 100% accuracy rate since 1990!” But when they expand the data past 1990, they discover that the indicator isn’t very accurate at all! Perhaps the indicator does a very poor job at timing corrections and bear markets when they insert more historical data.
The more data an indicator incorporates, the more reliable the indicator is. There are very few indicators that have been consistently accurate throughout the entire 20th and 21st centuries AND still make logical sense (i.e. aren’t just pure mathematical coincidences that offer no predictive value). But when you do find an indicator that is timeless, the indicator is especially powerful. Our model is based on these timeless and logical indicators.
Small problem with VIX
VIX can breakdown when the market moves rapidly. VIX is essentially based on options volatility. When the market is moving rapidly, volatility fluctuates rapidly as well. Hence VIX will become very wild and will sometimes show “flash spikes” or “flash crashes” that only last for a few seconds.
This happened last year. When the S&P crashed in January 2016, VIX’s intraday bar chart showed a lot of long upper and lower bars. This meant that VIX would spike for a second and then come back down. Then VIX would crash for a second and then come back up. This pattern repeated hundreds of times during the day. Essentially, VIX had broken down.

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