Has the VIX lost its use as a fear gauge?

We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Asset Allocation Model is an asset allocation model that applies trend-following principles based on the inputs of global stock and commodity prices. This model has a shorter time horizon and tends to turn over about 4-6 times a year. The performance and full details of a model portfolio based on the out-of-sample signals of the Trend Model can be found here.

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the email alerts is updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

• Ultimate market timing model: Buy equities (Last changed from “sell” on 28-Jul-2023)
• Trend Model signal: Bullish (Last changed from “neutral” on 28-Jul-2023)
• Trading model: Bullish (Last changed from “neutral” on 22-Sep-2023)

Update schedule: I generally update model readings on my site on weekends. I am also on X/Twitter at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of those email alerts is shown here.
 

Subscribers can access the latest signal in real time here.

VIX as fear gauge

There have been a series of recent articles highlighting the subdued level of the VIX Index and the seasonal tendency for equity volatility to spike this time of year (see this Barron’s article as an example). Other analysts have speculated that the VIX Index is failing as a fear gauge.

I have few opinions on the seasonality of the VIX, though last week has historically been a weak one for S&P 500 returns. However, I beg to differ on the use of the VIX as a fear gauge.

That’s because the VIX Index was not designed to be a fear indicator. It was designed to measure the implied volatility of a series of at-the-money options with a 1-month time horizon. While some analysts have seized upon implied volatility for use as a fear gauge, the index was never intended for use that way.
 

Indeed, the current explosion in 0DTE trading, or options that expire the same day, makes a 1-month implied volatility have less utility as a sentiment indicator. Arguably, VXST, or the 9-day VIX, is more useful to measure short-term sentiment. The accompanying chart shows that VXST was faster to spike in the current instance than VIX. The term structure of the VIX-VXST curve shows an inversion, which is an indication of fear appearing in the market.

 

The key question for investors is whether fear levels are high enough for a short-term bottom.
 

Regular readers will recall my Trifecta Bottom Spotting Model, which was triggered under the following circumstances:

1.    The term structure of the VIX inverts, as measured by the ratio of the 3-month to 1-month VIX;
2.    TRIN spikes above 2, which indicates price-insensitive selling, or a “margin clerk market”; and
3.    The intermediate-term overbought/oversold model, which is the ratio of the percentage of stocks above their 50 dma to percentage above their 150 dma, falls below 0.5, which is an oversold condition.
 

Based on the strict criteria of the Trifecta Model, there is no buy signal. However, the 1-month to 9-day VIX has inverted, which would flash a provisional exacta buy signal, which has shown itself to be similarly effective at calling tactical bottoms.

Can support hold?

I pointed out in the past that whenever the 5-week RSI of the S&P 500 reached over 90, the market pulled back, rallied and weakened to test the previous low.  My base case in the latest pullback called for initial S&P 500 support at about 4350, with secondary support at the 200 dma at about 4200. Now that the index has reached 4350, can this initial support hold?
 

The chances are good. Past pullback-rally-pullback patterns always saw the 5-week RSI weaken to an equal or lower low (check). As well, the second pullback in these patterns terminated when the NYSE McClellan Oscillator (NYMO) reached an oversold reading (check).

 

In addition, two of the four components of my Bottom Spotting Model flashed a buy signal after the market close on Thursday when the VIX Index spiked above its upper Bollinger Band and NYMO oversold. Such conditions have been bullish signals with strong risk/rewards in the past.

For illustrative purposes, the chart also shows the intermediate-term overbought/oversold model from the Trifecta Model, though it’s not an official component of the Bottom Spotting Model. Nevertheless, it does show how stretch conditions are to the downside.

 

Additionally, Samantha LaDuc reported that dealers are massively short the VIX to the zero percentile over the survey period. By implication, they are massively long equities.
 

 

The bear case

Keep in mind, however, that oversold markets can become more oversold. It’s possible that the market may need a final flush before a durable bottom can be made, indicating further downside potential.
 

An analysis of market internals reveals a series of negative divergences. While the S&P 500 tests its August lows, other indicators are showing a series of lower highs and lower lows.
 

 

A scan of other high-beta groups, such as small-caps, and the cyclically sensitive home construction and semiconductor stocks, are tracing out head and shoulders technical patterns with considerable downside potential.

 

Technical analyst Wayne Whaley conducted a historical study and found that years with similar return patterns as 2023 saw a bearish final week of September, followed by strong price recoveries in each of the remaining months of the year.
 

 

Before you become too bearish, Ryan Detrick conducted a more detailed historical study of daily S&P 500 seasonality and found that the last two weeks of September tend to be negative, thought the returns in the final week were less bearish. In practice, much will depend on the level of market anxiety over the prospect and possible effects of a U.S. government shutdown on September 30, though the historical evidence shows that shutdowns have had little or no effect on stock prices.
 

 

That said, the latest update from FactSet shows the first decline in forward 12-month EPS estimates in some time. It remains to be seen whether the downward revision was just a data blip or the start of a bear trend.
 

 

In summary, I rhetorically asked if the VIX has lost its usefulness as a fear gauge. In this era of 0DTE option trading, VXST is a more useful sentiment indicator, and readings are indicating a fear spike. The market has become sufficiently short-term oversold that a relief rally is imminent. However, oversold markets can become more oversold and market internals could be supportive of one final sentiment flush before a durable bottom can be seen. If the market were to weaken further from here, strong S&P 500 support could be found at its 200 dma at about 4200. I estimate the odds of the market holding support at the current level at roughly 75% and further weakness down to 4200 at about 25%.

Subscribers received an alert Friday morning that my inner trader had initiated a long position in the S&P 500 and he plans on averaging in over the next few days. The usual disclaimers apply to my trading positions.

I would like to add a note about the disclosure of my trading account after discussions with some readers. I disclose the direction of my trading exposure to indicate any potential conflicts. I use leveraged ETFs because the account is a tax-deferred account that does not allow margin trading and my degree of exposure is a relatively small percentage of the account. It emphatically does not represent an endorsement that you should follow my use of these products to trade their own account.  Leverage ETFs have a known decay problem that don’t make the suitable for anything other than short-term trading. You have to determine and be responsible for your own risk tolerance and pain thresholds. Your own mileage will and should vary.

 

 

Disclosure: Long SPXL