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VIX Forecasts Turbulent Year Ahead

Last year was the year of low volatility in the broad market. As measured by the CBOE Volatility Index (VIX), the index made lower lows and corresponded with the 2004 consolidation year. Ironically, the bears were shouting from the housetops that the low VIX readings were commensurate with a coming stock market crash. Actually, just the opposite was true as we argued back then.

Higher volatility is a function of speculative excess and that's what we've seen so far in the early part of 2005. It should therefore come as no surprise that VIX is actually on the rise again -- much like interest rates -- and I expect overall levels of volatility to be on the rise throughout the year.

Market strategies Don Hays (www.haysmarketfocus.com) shares this outlook in his recent statement, "It is my guess that the money managers that have the best performance at the end of this year will simply be the ones that have learned to bob and weave the best during the 2 or 3 bouts of upside/downside volatility we expect for this volatile year."

Perversely, the super bulls are now using increased volatility as an argument for their exaggerated bullish outlook. Overheard on CNBC recently: "The rising levels of volatility are a sign of increased buying interest." Once again, the Streeters have it exactly backwards as increased volatility coming off major lows is not a good sign.

As you can see here, the VIX daily chart looks like has been on the up and up recently, having just broken out to a higher high (after tracing out a bullish triangle pattern) and has established an immediate-term uptrend above its rising 5/10/15-day moving averages. You can also see a positive divergence in the daily MACD indicator for the VIX, a technical indication of a higher series VIX readings to come.

Ultimately, an increase in stock market volatility is a function of cross-currents created by cycles that are bottoming and peaking simultaneously or at close intervals. For instance, after the 10-year cycle bottomed last October (producing the broad market rally into early 2005) the next of the longer-term cycles that will influence the market this year is the 6-year cycle, which is due to peak later in the year. Whenever the 6-year cycle peaks it tends to produce not only volatility, but sometimes it even results in waterfall declines during the actual peak. But before the peak hits the still-rising 6-year cycle is buoyant enough to allow for some spirited rallies.

Then there is the Kress Master Trading Cycle of 120 weeks that is also due to bottom this year ahead of the 6-year cycle peak. These two major cyclical events, combined with the smaller tops and bottoms, will only add fuel to the volatility fire.

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