The VIX Is Cheap - Is It Time To Buy?

In our search for value among various asset classes, we concluded that - generally speaking - stocks are fairly to slightly overvalued, bonds are extremely and historically overvalued, commodities in general and gold in particular, while not cheap by historical standards, could be ripe for a playable rally, and that real estate is no longer cheap.

However, we did find that "volatility" or more specifically, volatility premium (aka the VIX) does appear to be cheap when looking at the big-picture.

But for starters, let's define what the term, or in this case, the asset class of "volatility" means. According to Investopedia, "The Chicago Board Options Exchange (CBOE) Volatility Index shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the 'investor fear gauge'"

So, the first thing to understand about "Vol" is that it really isn't a thing. Nope, the CBOE Volatility Index is simply a measure of expected volatility in the market. And right now, the expectations for market volatility are at VERY low levels.

The chart below shows the VIX on a monthly basis for the past 25 years.

CBOE Volatility Index (VIX) Monthly from 1990

As the red circles indicate, the current levels on the VIX are exceptionally low and on a monthly basis, are near the levels seen in 1994 and 2007.

But the second key point to this morning's missive is that just because an asset is "cheap" doesn't tell us much about when it might go higher. So, to ensure that there is no confusion, the current level of the VIX does not, in and of itself mean it will rally furiously any time soon. The current levels just mean that one should expect volatility to spike higher at some point in the future.

Volatility Primer - Fear Is a Good Thing

Although it is a bit of a misnomer, the VIX is often called the fear gauge. However, this is one of those chicken-or-the-egg situations as traders often look to the VIX for clues about what might happen next in the market. Yet the bottom line is that expectations for volatility (the VIX) increases as fear increases - and not necessarily before.

The chart below shows how the expectations for volatility tends to spike around crisis events.

CBOE Volatility Index (VIX) Weekly from 2009

This weekly chart of the CBOE Volatility Index makes it clear that when crises hit, volatility tends to spike - sometimes A LOT. For example, the left side of the chart is the tail end of 2008 - a time when the credit crisis was raging and fear was at historically high levels.

To put the magnitude of the fear that was in the market during this crisis into perspective, look at the monthly chart again and note that the 2008 spike was more than 50% higher than anything seen prior. And then also note that the monthly chart illustrates the VIX on a closing basis. During the crisis of 2008, the VIX spiked to almost 90 (the very top of the chart) on an intra-month basis - yikes!

As one can plainly see on the weekly chart just above, the VIX surged by more than 130 percent during the first go-round with Greece in 2010 and again in 2011. And then the index has made several moves of 50 percent or more in the last 5 years. So, being long volatility via something like the iPath VIX Short-Term ETF (VXX) at the right time can be VERY profitable. However, PLEASE note that ETFs such as VXX and VIXY are SHORT-TERM TRADING VEHICLES ONLY and SHOULD NOT be used as an investment position!

A New Era?

Another important takeaway from the weekly chart of the CBOE's VIX is that expectations for volatility have been quite low since the beginning of 2013. Some analysts even argue that the market has now entered a "new era" of low volatility in the market. We shall see.

The next chart shows the CBOE Volatility Index on a daily basis over the past 18 months.

CBOE Volatility Index (VIX) Daily

If one were to look only at this chart, they would likely conclude that the VIX tends to trade in a range. As such, employing a "ride the range" strategy (buy the low end of the range and sell the high end of the range) looks to be a no-brainer. For example, buying whenever the VIX hits 12.50 and then selling a portion over 16 appears to be a profitable approach.

However, the big problem with this tactic is two-fold. First, trading ranges can change. And second, when this particular asset moves, it moves VERY fast as double-digit gains or losses in a single session are quite common (for example, the VIX spiked up 32.2 percent on July 17 as traders began to panic over the Russia/Ukraine situation). As such, being on the wrong side can be very painful.

But... The Rubber Band IS Stretched!

The final point to take away from this exploration of the VIX is that this is the 3rd longest streak in the last 25 years (688 days to be exact) without a spike of 100 percent or more in VIX.

Think about that. Over the last 25 years, there have only been two other occasions where the VIX didn't at least double at some point. For reference purposes, the other two periods of low volatility environments were 1990 through 1994 and 2003 through 2007.

The Big Finish

And now for the big finish. The key is to recognize that, in the past, whenever the market has experienced a long period of low volatility, a spike of 100 percent or more has followed and that being "long vol" has been exceptionally profitable.

Another way to look at this is that periods of low volatility tend to be followed by a return to a high volatility environment. Therefore, investors may want to be ready to jump into some "vol" the next time something strikes fear in the hearts of traders.

But please, please, please remember - buying and holding an ETF like the VXX, VXZ, or VIXY can be hazardous to your portfolio's health due to the decay that occurs in these vehicles.

Thus, the best way to play this game is to patiently wait for some fear to present itself and then to jump on board the move - quickly. Oh, and then you will need to be ready to jump out of the move at the drop of an algo - unless of course a new crisis is actually developing, that is!

Turning To This Morning

All eyes are on Apple this morning as the company is expected to introduce new iPhone lines, a new mobile payment system, and some sort of "wearable" which people are calling the iWatch. The big event kicks off at 1:00 pm eastern time. Across the pond, Industrial Production surged in the UK while BOE Governor Carney said that the time for interest rates to rise is coming closer. Stock markets are mixed in Europe and U.S. futures are pointing to a slightly higher open after losing ground in four of the last five sessions.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    - Japan: +0.28%
    - Hong Kong: closed
    - Shanghai: +0.02%
    - London: -0.01%
    - Germany: -0.05%
    - France: -0.09%
    - Italy: +0.20%
    - Spain: -0.35%

Crude Oil Futures: +$1.07 to $93.94

Gold: +$2.80 at $1256.80

Dollar: lower against the yen and pound, higher vs. euro.

10-Year Bond Yield: Currently trading at 2.502%

Stock Indices in U.S. (relative to fair value):
- S&P 500: +1.06
- Dow Jones Industrial Average: +3
- NASDAQ Composite: +2.64

Thought For The Day:

Only put off until tomorrow what you are willing to die having left undone. - Pablo Picasso

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Current Market Drivers

We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).

      1. The State of the Geopolitical 'Issues'
      2. The State of Fed/ECB Policy
      3. The Level of Interest Rates
      4. The Outlook for U.S. Economic Growth

The State of the Trend

We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:

Short-Term Trend: Neutral
(Chart below is S&P 500 daily over past 1 month)

Intermediate-Term Trend: Moderately Negative
(Chart below is S&P 500 daily over past 6 months)

Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 12 months)

Key Technical Areas:

Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:

  • Key Near-Term Support Zone(s) for S&P 500: 1900(ish)
  • Key Near-Term Resistance Zone(s): 1960

The State of the Tape

Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...

Trend and Breadth Confirmation Indicator (Short-Term): Neutral
Indicator Explained

Price Thrust Indicator: Negative
Indicator Explained

Volume Thrust Indicator: Negative
Indicator Explained

Breadth Thrust Indicator: Neutral
Indicator Explained

Bull/Bear Volume Relationship: Moderately Positive
Indicator Explained

Technical Health of 100 Industry Groups: Neutral
Indicator Explained

The Early Warning Indicators

Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.

  • S&P 500 Overbought/Oversold Conditions:
          - Short-Term: Moderately Oversold
          - Intermediate-Term: Moderately Oversold
  • Market Sentiment: Our primary sentiment model is Positive .

The State of the Market Environment

One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.

Weekly State of the Market Model Reading: Neutral
Indicator Explained

Looking For Guidance in the Markets?

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The Insiders Portfolio: If you are looking for a truly unique approach to stock picking - Check out The Insiders Portfolio. We buy what those who know their company's best are buying - but ONLY when they are buying heavily! P.S. The Insiders is up over 30% in 2013 and has nearly doubled the S&P 500 since 2009.

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Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com
President, Heritage Capital Research
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The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of StateoftheMarkets.com and may not actually come to pass. The opinions and viewpoints regarding the future of the markets should not be construed as recommendations of any specific security nor specific investment advice. One should always consult an investment professional before making any investment.

Posted to State of the Markets on Sep 09, 2014 — 8:09 AM
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