Stock Chartist

March 17th, 2010

Ignore The VIX As A Market Trend Indicator

A friend said “A major correction is coming.” When I asked how they knew, the answer was “Because the VIX has declined significantly from its high of near 80 at the end of 2009 and is now under 18″.

If it was so easy to predict future market direction from the VIX’s level then why should I spend so much time with trendlines, moving averages and, when needed, other technical indicators like stochastics and Fibonacci levels. The answer, not surprisingly, is that the VIX isn’t a good forecasting tool other than perhaps extremely short-term fluctuations. Since this question surrounding the VIX seems to be on many investors minds now that the market seems to be moving out of its narrow, 6-month lateral trading range, I decided to do my own form of research.

Coincidentally, I found Laszlo Birinyi coming to essentially the same conclusion in a recent Bloomberg article entitled “VIX Doesn’t Work as Signal for U.S. Stock Returns, Birinyi Says“. Birinyi writes:

“Speculation that equity returns will be positive after the volatility gauge decreases and negative when it climbs has little basis in fact, Birinyi said. The VIX provides a summary of historical price swings and tends to move in lockstep with equities instead of forecasting their direction…..The VIX is a coincidental indicator,’’ Birinyi wrote. ‘‘It details, perhaps better than other measures, the volatility of the market today but not tomorrow or the day after.’”

If you’ve been brainwashed by some of the talking heads on CNBC then perhaps this long-term chart of the VIX with the S&P 500 Index superimposed on it for comparison might persuade you (click on image to enlarge):

True, the VIX had an inverse relationship with the Index during 2008-09, but throughout the long 1986-2000 bull market, the VIX trend bore little connection with the Index having trended down and then up (indicated by the solid blue 300-day moving average) during most of the period. During the last bull market between March, 2003 and December, 2007, the VIX again fell and then rose as the market climbed from trough to its peak.

Falling VIX is interesting but I welcome it rather than finding it something to be fearful of. If the last two bull markets are reasonable precedent, I could see the VIX continuing to decline another 40-50% from current levels to around 10.0 (the previous lows) while I simultaneously watch the S&P 500 continue climbing into new all-time high territory over the next several years.