15/10/2014: Will a correction in the VIX signal the next low?

I focused on what I saw as a turnaround in sentiment in the Morning Report today. The rebound in Dollar/Yen and the weakness in the gold price suggested to me that the flight to safety may be abating. However the other factor I am interested in is the VIX Index of S&P 500 options volatility, which I believe could be a signal that points to a bottom in the recent selling pressure in the market.

First of all look at the volume in the VIX. The volume of the number of contracts has also increased enormously in the past few days, culminating in yesterday’s volume on the VIX at 1.63m which was the highest volume since March. This suggested that fund managers were scrambling to purchase insurance for their portfolios (ie. buying put options). Demand for portfolio protection has rocketed.

VIX vol   15102014

This increase in demand has seen the VIX spike well over 20 in the last week. Over the course of a 3 day period the VIX jumped by over 50%.  However yesterday the VIX started to decline, falling by 7.5% on the day. This may well be a one off correction, however, as you can see in the chart below, spikes in the VIX are consistent with key lows in the S&P 500 over the past couple of years. So, all we need is for the VIX to start to fall and this will result in a rebound for the market…?

SPX   15102014

There are two big caveats to this view. FIrstly, the spike in the VIX could continue higher. However secondly, more importantly its that this is a bull market view as it remains dependent on the outlook that this is not the beginning of a new bear market.

In light of that the European indices have continued to decline today, with the German DAX around 0.7% lower and the FTSE 100 around 1.0% lower. For now though the recent lows (8700 on DAX and 6300 on FTSE 100) remain intact. The S&P 500 index futures have ben fluctuating throughout the morning and currently suggest the S&P 500 will open around 2 points lower at the open.

US Retail Sales have not fallen month on month since January, but the expectation is that there will be a -0.1% move today. This would certainly not help sentiment. However the big US banks earnings have started reasonably solidly, with the hope that Bank of America Merrill Lynch will follow the decent showing from JPMorgan Chase, Citigroup and Wells Fargo yesterday.

Just as a final thought, the yields of safe haven sovereign debt such as Treasuries, Gilts and Bunds may also need to show an improvement to also confirm the improvement in investor sentiment. This does not seem to be happening quite yet.

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