The Volatility Index (VIX)

The volatility indices measure the implied volatility for a basket of put and call options related to a specific index or ETF. The most popular is the CBOE Volatility Index (VIX), which measures the implied volatility for a basket of out-of-the-money put and call options for the S&P 500. Specifically, the VIX is designed to measure the expected 30-day volatility for the S&P 500.

Market Volatility Correlation

Back in December, we published a note on the breakdown in the correlated relative volatility between the Volatility Index (VIX) and the S&P 500 (SPX). By examining these trends and trends in the Put/Call ratio we noted the obvious trepidation of market participants, but noted that we were at levels that preceded a market rebound.

After taking our more aggressive bullish stance towards the end of last year, we have been able to capitalize on a strong move higher from the start of the year.

In figure 3, the gray line represents the correlation between VIX / SPX volatility. One can see that when this correlation breaks down (rises closer to zero), as it had been since late March 2011, the stock market headed lower. Since then, we topped out at -2.5 in mid-February and started lower. Given that this correlation is one of the metrics in our behavioral model, it prompted us to start taking profits and start to look for a potential pullback in the markets.

The current reading of -5.5 signals that we may have some upside remaining, but the trend will suggest a much needed retrenchment on the horizon.

Market Complacency

There has been an extreme case of complacency that has set into the market today. When looking back at the historical VIX over the past few years, it seems the $15 level is the point of complacency that usually precedes a market drop. We downloaded a chart from stockcharts.com and put it as figure 6 in this report to show our point.

Bottom Line: We have taken significant profits for the first quarter of the year and are now looking for a near-term correction in the market. While our long-term outlook remains bullish, our shorter-term outlook is bearish and we are preparing for a market correction.

Joseph S. Kalinowski, CFA