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Is The VIX Flashing A Buy Signal?

Everyone, including us, has referenced the VIX or Fear Index's current low level as a possible point of concern for an imminent reversal in stocks. We remain concerned about the VIX. However, a bullish case can also be made based on history.

Can the VIX drop further? You bet it can. The VIX hit a low of 10.03 in 2007, which means it would have to fall an additional 35% to reach the 2007 "historic low". The VIX also dropped to 9.31 in 1994, which would require an additional drop of 39% from current levels.

When the VIX falls, it indicates fear is subsiding or tailing off. Are there periods where it makes sense to have a reduction in fear? Sure. The current argument would be the market (right, wrong, or indifferent) feels the systemic "Lehman-type" event has been taken off the table due to the European Central Bank's unlimited three-year loans. If the market turns out to be right, then it would be logical for the VIX to drop and for stocks to rise.

The weekly chart below shows the VIX, the VIX's 200-week moving average (MA), and the S&P 500 Index (bottom). In mid-2002 the slope of the VIX's 200-week moving average began to tick down, which is very similar to what happened in early 2011. In 2002, stocks dropped quite a bit further before the VIX's 200-week moving average started to tick down again in 2003 - very much like what we experienced in 2011 and are now seeing in 2012. From the period where the slope of the 200-week turned down (2003) to where it turned back up (2007), the S&P 500 gained 55% (period between green and red vertical lines).

$VIX (Volatility Index - New Methodology) INDX

Does this analysis negate all the bearish interpretations of the current VIX? Absolutely not, but it does give us some balance and perspective based on observable evidence (the slope of the 200-week MA). From a bearish perspective for stocks, the slope of the 200-week above has not turned down yet in a convincing manner, but it has the look of trying to roll over.

Another fair question to ask is - "Do the big picture technicals support further gains or an imminent crash?" The answer, whether we agree with it or not from a fundamental standpoint, is "further gains". We believe the systemic risk in the financial system remains elevated and needs to be respected. However, it does not matter what we think - it matters what the market thinks. As long as conditions remain favorable, we will participate, but with a skeptical and watchful eye.


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