On September 25th I shared in VIX level shows market’s expectation of future volatility when I pointed out a low level of expected volatility as implied by the VIX index.
The current level of the VIX index has settled down to a lower historical level suggesting the market expects the future range of the price of the S&P 500 to be lower. Below is the current level relative to the past year.
I went on to explain my historical observations of volatility cycles driven by investor behavior:
The VIX Index is intended to provide a real-time measure of how much the market expects the S&P 500 Index to fluctuate over the next 30 days. The VIX Index reflects the actual order flow of traders
Since investors tend to extrapolate the recent past into the future, they usually expect recent calm markets to continue and violent swings to persist.
After the stock market declines and volatility expands, investors extrapolate that recent experience into the future and expect volatility to continue. Sometimes it does continue, but this time it gradually declined as the price trend became calmer.
When markets have been calm, traders and investors expect volatility to remain low. Before February, the VIX implied volatility had correctly predicted low realized volatility for months. But, both realized and expected volatility was so low that many investors were shocked when stock prices fell sharply, and volatility expanded.
When the market expects volatility to be low in the next 30 days, I know it could be right for some time. But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.
I shared the chart below, showing implied volatility at the low end of the cycle over the past year:
Since that date, we’ve indeed witnessed a volatility expansion of more than 90% in the VIX index and a decline in the S&P 500 stock index over -6%. Implied volatility has expanded and stocks declined. As implied volatility is now starting to contract, below we can see the recent expansion as it trended from 12 to 24. Today its back to its long-term average of 20.
Stock market indexes, both U. S. and international, have declined 6 – 7% from their highs.
At this point, this has been a normal short-term cycle swing in an ongoing uptrend that is frequently referred to as a “correction.”
To be sure, we can see by looking at the % drawdowns in the primary uptrend that started in March 2009.
Markets cycle up and down, even within overall primary uptrends. As we see over a nine-year period, the current decline is about average and half as deep as the largest declines since 2009.
You can probably see what I meant by situational awareness of the markets cycles, trends, and volatility levels.
It isn’t enough to just say it or write about it. My being aware of the situation helps me to do what I said, which is worth repeating:
But, when it gets to its historically lowest levels, it raises situational awareness that a countertrend could be near. It’s just a warning shot across the bow suggesting we hedge what we want to hedge and be sure our risk levels are appropriate.
As far as the stock market condition, I like to see what is going on inside. Just as volatility swings up and down in cycles, so do price trends. As I’ve pointed out before, I observe prices swinging up and down often driven by investor behavior. For example, many investors seem to oscillate between the fear of missing out and the fear of losing money.
“The less the prudence with which others conduct their affairs, the greater the prudence with which we must conduct our own.” – Warren Buffett
One visual way to observe the current stage is the breadth of the stock market as I shared last week in The Stock Market Trend. Below is the percent of stocks in the S&P 500 index trending above their 50 day moving averages often used as a short-term trend indicator. This is a monthly chart since 2009 so we can see how it oscillates up and down since the bull market started. At this point, the number of stocks falling into short-term downtrends is about what we’ve seen before.
The risk is: this continues to be an aged old bull market, so anything is possible. That is why my focus every day is situational awareness. But, there is always a risk of a -10% or more decline in the stock market, regardless of its age or stage.
The good news is, we’ve now experienced some volatility expansion, stocks have now pivoted down to the lower end of their cycles, so maybe volatility will contract and stock prices resume their uptrend.
All that is left to do is observe, be prepared, and respond tactically as it all unfolds.
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