It’s been quiet on Wall Street, suspiciously quiet.
Investor fear — as measured by the CBOE Volatility Index VIX, -6.57% — is slowly drifting lower. In fact, the VIX just dropped below 15 (which has been historically significant support) for the first time since October. (More about that in a moment.)
Real time (or actual) volatility has dropped even more than implied by the VIX. A simple but accurate way to gauge real or actual volatility is to measure the difference between the S&P 500’s SPX, +0.64% daily high and low over a period of time.
Last December, the S&P 500 moved as much as 5.16% a day, a 121-point difference between the day’s high and low. This month, the S&P 500 moved as little as 0.48%, or 13 points from daily high to low.
The five-day average (or simple moving average, SMA) of maximum daily moves dropped from 3.67% in December to 0.66% in February. That is the largest drop in actual volatility since August 2011.
The chart below plots the S&P 500 against the five- and 20-day SMA of maximum daily percentage swings. The red arrows and blue bars highlight periods of time when average daily swings quickly dropped from high to low.
Although two of three times the S&P 500 did not even get close to re-testing the panic low, every single time there was a pullback. The smallest such pullback, in June 2018, was 100 points.
VIX analysis
As mentioned above, the VIX fell below support around 15 for the first time in months.
The chart below highlights the four other times (in the past decade) when the VIX closed below 15 for the first time in at least three months.
The blue box starts with the first signal and highlights the following three months. Three months after the initial signal, the VIX was higher every time, 29% on average.
Following the VIX’s first drop below 15, the S&P 500 fell each time thereafter, or at the minimum offered a better entry level to buy at.
In summary, periods of low volatility usually end up being the calm before a storm, but most storms don’t turn into a hurricane.
Although the above research is based on the S&P 500, back-testing shows similar results for the Dow Jones Industrial Average DJIA, +0.70% Nasdaq COMP, +0.91% and Russell 2000 RUT, +0.92%
Actionable ideas
Based on the above analysis, there are three potential trades:
1. Buy the VIX. Disadvantage: ETPs like the iPath S&P 500 VIX ETN suffer from contango (price erosion caused by the cost of rolling over expiring futures). It takes impeccable timing and a big VIX move (at least 10%) to make money with VXX.
2. Sell stocks: S&P 500 resistance is at 2,790-2,835 points. A pullback is likely, though the larger trend appears to be higher still.
3. Buy the dip.
Trade No. 3 is probably the best approach for the average investor. Why? The weight of evidence points to further gains, ideally after a pullback. Trading with the prevailing trend is usually the prudent approach.
Exactly which indicators point to more long-term gains was discussed here over a month ago.
Simon Maierhofer is the founder of iSPYETF and publisher of the Profit Radar Report.
