A Little Fear About The FEAR Index

Back on November 13, 2014, we wrote about our concern over elevated volatility as part of our seven-part series on evidence currently warning of a possible trend change in the overall U.S. Equity market. Almost two months later, none of the issues identified have resolved and remain cause for concern that stocks are weakening and could lead to a large correction. The only piece of evidence, and the most important, that has held up is price. Since November 13, the S&P 500 has traded sideways in a volatile fashion with large percentage moves in either direction. The market is at a very important inflection point. Buyers need to step up in a big way to prevent another visit to the 1800s (-10%) on the S&P 500.

This brings us back to revisiting what is currently taking place with the FEAR Index, or VIX. As a reminder, the CBOE Volatility Index (VIX) is a forward looking instrument calculated from option activity, and reflects the market’s expectation of 30-day volatility. We like to look for divergences between the VIX and the US Market. We look for odd behavior. Normally, as would be expected, when fear/volatility increase, stocks decrease in price – and vice versa. However, sometimes a change in market sentiment from greed to fear (and the opposite also applies) can tip its hand. When we see fear/volatility increase along with market prices, we take notice. This is odd behavior and could be a warning sign that market participants (big money managers) are changing their mood. This was taking place back in November and continues to be an issue today. As George Soros once noted:

Volatility is greatest at turning points, diminishing as a new trend becomes established.

The chart below is an updated version of what we provided you back November. Note that volatility has continued to increase, both in the VIX and now in the price fluctuations of the market. This needs to resolve quickly. Those long this market need volatility to drop and new highs in the market to reestablish. Otherwise, the opposite will apply – new highs on the VIX and new lows in the market. A revisit to the 1800s would be likely. This market will require traders be nimble in the coming weeks+. Keep in mind that price is the final arbiter of value.

For your reference, I’ve provided a chart of this scenario from the 2007 top below the current day chart. This doesn’t have to play out again, but we should always sit up and take notice when volatility increases.

Trade safe. Don’t trade what you think. Trade what you see.