June 16th, 2011
Follow up:On April 27th, we took an initial look at the S&P 500 as priced in $VIX units (the ratio of $SPX:$VIX). What it exposed at that time was that the market was likely due for a pullback. Indeed, only days later the May 2nd high was registered and the market has dropped ever since. But whether the May 2nd top was ‘the’ top or not, it has become apparent that the expectations of what the $VIX itself should be doing when the market sells off are correct, but investor expectations about ‘when’ the $VIX will explode higher are not.
In the chart below, we look back to April 27th when the first article was presented, and see what the ratio of the S&P 500 as priced in $VIX units looked like at that time. Here’s the accompanying chart, complete with the annotations as they appeared in late April when the ratio suggested a top might be imminent:
In the chart below, we see what this ratio looks like today… after 6 straight weeks of declines in equities. Nothing has changed except that equities have indeed fallen as the original analysis suggested, and the ratio itself has continued lower as we expected it might:
This is where many investors fail in their understanding of any ratio analysis; it doesn’t matter which of the two components is contributing the lion’s share of change. Specifically, if it has been clearly demonstrated that a change in a meaningful ratio is consistently accompanied a change in the direction of the target of study (in this case the $SPX), then the fact that the ratio has changed direction is all that matters. It has done its job. In this particular example, in the final week of April this ratio suggested that the S&P 500 was probably due to correct, and that’s exactly what has happened since May 2nd. In retrospect, it is now clear that of the two components which make up the ratio, it has been the S&P 500 which has surrendered the vast majority of the impetus required to make the ratio drop. But past history already told us that would be the likely outcome if the ratio turned lower. Once the ratio has issued a signal, we then turn our focus to the subject of the analysis… in this case the S&P.
But questions still remain; “Why didn’t the $VIX surge higher when the market recently lost 7.7% in 6 fast weeks?” Great question! Which leads to the following questions; “Whether we have seen ‘the’ top or not, once a true market top is in, when will the $VIX surge higher in confirmation?” “Will the $VIX turn out to be a truly useful tool and notify us when a top has occurred?” In order to try to answer those questions, I’ve added a panel to the charts you’ve already seen so that we can investigate exactly what was happening with the $VIX in previous market corrections. We already know that when the ratio drops, the markets correct (or at least that a correction is likely imminent). But what does the $VIX itself do? We investigate those questions beginning with the chart below:
I want to make it clear that in presenting this study, I do not have a bias to argue for either the bearish scenario nor the bullish case. Admittedly, I am bearish and am quite convinced that there are underlying fundamental issues globally that strongly support a deflationary scenario. But I also openly admit that I could be entirely wrong about that. I simply want to point out that if we keep our eye on this ratio going forward, we will almost certainly gain further valuable guidance about the future path of the S&P. I have two main objectives today… to present an explanation that clarifies the questions about why the $VIX is not exploding higher at this stage of the game. And secondly, to provide the reader with links to a dynamic version of a couple of charts as they exist in my own library… for reference from this day forward.
Indeed, a valid argument for the bullish case can even be made by recognizing that at the present time, we do not see any negative divergence between equities and the ratio as existed back at the market top of 2007. Keep in mind that a neg. divergence is not mandatory. In fact, there currently exists a bullish divergence between the ratio and the S&P which suggests that a summer rally for equities is indeed possible. But if that’s what the future brings, the ratio will reflect it immediately. Equities will rise, the $VIX will fall, and the ratio will surge higher once again. Such an occurrence would only serve to further prove the wonderful reliability of ratio analyses. The bottom line though, is that as long as the ratio is falling, equities are headed south. If the ratio does indeed bounce, equities could be headed sharply higher. Unfortunately, there is one more fly in the ointment which we must not overlook. In the chart above, the MACD and stochastics of the ratio itself strongly suggest that the ratio will actually continue to fall. You can see that issue being addressed in the chart below in blue text.
To summarize then, there are three main observations presented here in graphical form that are purely mathematical and which are not really open for dispute. They simply provide excellent guidance which investors are free to use (or ignore) as they see fit:
a) When the ratio of $SPX:$VIX is falling, equities are either falling already, or will be falling soon.
b) In the early stages of market tops, we should not expect the $VIX to be rising significantly.
c) It is a mistake for investors to conclude that if the $VIX is not surging it represents a green light for higher equities prices. That is simply not the case. In the words immortalized by the great Forrest Gump; “To each, his own caca smells sweet. Do not be fooled by this.”
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