THE VIX IS STARTING TO RISE -- CONTRARY TO POPULAR OPINION, IT'S DONE A GOOD JOB SO FAR

VIX REACHES TWO-MONTH HIGH... It's been a long time since I've written about the CBOE Volatility (VIX) Index. A lot of people have dismissed it as no longer having any forecasting value. That may explain why we haven't heard much about its recent rise. When no one is paying attention to the VIX, that's usually the best time to start paying attention. The VIX measures market volatility. Historically, the VIX trends in the opposite direction of the market. A falling VIX is usually bullish; a rising VIX is usually bearish. Charts 1 and 2 compare the VIX (Chart 1) with the S&P 500 (Chart 2) for the last six months. You can clearly see them trending in opposite directions. Try comparing the arrows. The green down arrows in Chart 1 show VIX peaks in August and October, which coincide with up arrows (bottoms) in the S&P 500. The red arrow in the VIX at the start of October coincided with a short-term peak in the S&P 500. Which brings us to the present. The VIX is trading over 14 for the first time in two months. If that's just a minor blip, it should coincide with a short-term downside correction in the S&P 500. If the VIX upturn is more serious, so will the S&P 500 downturn. I'm watching the (green) down trendline drawn over the August/October peaks in the VIX. If the VIX were to surpass that line, I'd start turning more cautious on the market. If the VIX were to surpass its late October peak at 17, I'd become even more concerned. Let's see why.

Chart 1

Chart 2

Chart 3

Chart 4


THE VIX HAS DONE ITS JOB... Charts 3 and 4 show that the VIX and the S&P 500 have maintained their inverse relationship throughout the cyclical bull market that started in late 2002. The green circles during the second half of 2002 show the VIX peaking as the S&P 500 was bottoming. The VIX peak in the spring of 2003 (see green arrow) coincided with a major upturn in the S&P 500. A bounce in the VIX at the start of 2004 (see red circle) coincided with a downturn in the S&P. The VIX downturn in August (down arrow) coincided with the last S&P upturn. It seems to me that instead of not working, the VIX has been doing exactly what it should have been doing for the last three years -- that is, correctly signaling an ongoing bull market. Which is all the more reason why we should pay attention to it in case it starts to change direction. So far, the rise has been modest. I mentioned in paragraph one that a VIX rise over 17 would be cause for concern. Chart 3 shows why. That would not only push it through a resistance barrier at its late October high (and reverse the three-year pattern of falling peaks and troughs), but would also break its down trendline extending back to July 2002 (using a logarithmic scale). I'm not predicting that it's going to happen. But I am saying that the VIX needs to be watched closely at this point. With the market in what I believe to be the fifth and final upwave in its cyclical bull market, with the seasonally strong yearend period coming to an end, and the global bull market in overbought territory, there are lots of reasons to turn more cautious on the stock market. A rising VIX is another reason to be more vigilant -- especially if it rises enough to break its three-year downtrend.

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