SPIKING VIX INCREASES ODDS FOR FOURTH QUARTER BOUNCE -- WHY THIS ISN'T A GOOD TIME TO TURN TOO BEARISH -- MARKET MAY BE IN CAPITULATION PHASE
VIX TESTS 2008 HIGHS ... I wrote earlier in the week that a rising CBOE Volatility (VIX) Index carries both good and bad news. The bad news is that a rising VIX is associated with falling stock prices. The good news is that a high VIX reading is necessary for any significant market bottom to occur. On Monday, I showed the VIX rising above its July peak which signaled weaker stock prices. The question now is how high the VIX will rise before peaking. I was expecting the VIX to reach the peaks hit over the past year. Chart 1 shows it exceeding those intra-day peaks (although it reversed down today on a late stock rally). If it can hold onto that upside breakout through the end of the week, we would have to consider raising the VIX target to the highs reached during the financial crises of 1998 and 2002 (see Chart 2). Whether it reaches those earlier highs or not, a peak in the VIX is a necessary part of any market bottom. Today's lower close leaves the VIX slightly below its first quarter intra-day highs.
Chart 1
Chart 2
COMPARISON TO 2000-2002 BEAR MARKET ... The current bear market has lasted only half as long as the 2000-2002 bear and has lost only half as much ground. Some have asked if this could be a repeat of that earlier market drop. I don't have the answer to that, but I do think there's a good chance that the market will bounce during the fourth quarter. Take a look at Chart 3. It compares the S&P 500 (green line) to the VIX Index (red line) during the earlier bear market. The VIX spiked during the the third quarters in 2001 and 2002. Both spikes led to bottoms in the September/October period and fourth quarter rallies. The 2001 rally, however, lasted only until the first quarter of 2002 before turning back down. The October 2002 bottom turned out to be the real thing. I don't know which of those two scenarios matches the current situation. In either case, however, there's a good chance that the market is approaching a climax bottom of some type which could lead to a fourth quarter rebound. And it should coincide with a peak in the VIX. That's one of the reasons why I advised earlier in the week not to turn too bearish at this point.
Chart 3
WE'VE BEEN BEARISH FOR NEARLY A YEAR ... One of our readers asked why I wasn't "turning" bearish right now. The reason is that I"ve been bearish for most of the last year. Newer readers might want to review some of the bearish articles written during the fourth quarter of last year and the start of this year. I point that out to remind readers that the current bear market didn't start over the last week. It started nearly a year ago. We turned bearish at that point and recommended several bear market strategies (including bear funds). We also warned that global stocks had given a major sell signal during January. The reason I warned this week against "turning too bearish" now is that many of our longer-range indicators suggest that the bear market may have entered a capitulation phase that often marks fourth quarter bottoms. Not necessarily a final bottom, but possibly a bottom that could hold for the balance of the year. The spiking VIX is one of those indicators. That doesn't necessarily tell us when a "final" bottom is in place. It does, however, tell us when bearish sentiment is too high and the market selloff overdone. I suspect we may be approaching that point -- if we're not there already.
