You might have noticed that in last week’s sentiment overview, I didn’t include an analysis of the current volatility levels. This was for several reasons. First, I’m not sure that market volatility really belongs within the category of sentiment indicators. It is a quasi econometric indicator because it actually provides a reflection of underlying structural issues in the market, similar to the TED spread or any other credit or financial ‘stress’ index.
The second issue is that the recent low volatility has garnered a lot of attention and giving you my take on it would need a bit more nuance than the weekly sentiment overview allows for.
The knee jerk response is to interpret the kind of low volatility we are seeing as a bearish omen. For example, take a look at this chart comparing the CBOE volatility index (VIX) with the S&P 500 index (SPX):
That looks downright ominous! The VIX is down to 16. We last saw it at this level during two major market tops: May 2008 and April 2010. But jumping to that conclusion is premature. And a sign that you may be succumbing to the cognitive bias called ‘recency effect’ where more recent data points skew your judgment.
To avoid that we can zoom out a little bit more. We see that the VIX index was actually much lower in early 2007 and that by the time the equity market topped out in October of that year, the volatility index had actually risen by 50%. So there is clearly no direct and consistent relationship between a low VIX and market tops.
In fact, if we zoom out even more and look at the past 20+ years, we see that the VIX has tended to get stuck in compression zones for prolonged periods of time. And in those times, the equity market actually does rather well actually:
This is why I didn’t point out the VIX as an argument for a top heavy market. If you looked at the recent sentiment overview, there are plenty of other, much more cogent, reasons why this is a dangerous level for the bulls. We don’t really need to over-reach and use the low volatility index, even though the recency effect might provide us with a cautionary warning.
The corollary to the above is that the VIX is much more effective at pinpointing major market lows, where fear causes it to spike up. As you can see from the long term chart above comparing the volatility index with the S&P 500 index, there is no major market bottom that isn’t accompanied with a spike in the VIX.