by Umar Farooq
Investors are beginning to wonder if this Energizer Bunny of a rally can just keep going without taking a break or a fall. For the past couple of months, the question has hung in the back of investors’ minds: Is the stock market’s rally strong enough to continue without a correction?
The VIX measures the expected volatility in the S&P 500 index over the next 30 days and generally moves in the opposite direction of the broad market. Investors often use VIX options and futures as a hedge against a market decline. Most people understand that the VIX is intended to reflect the level of volatility or fear in the market, but the exact mechanism the VIX uses to measure volatility is more complex. The goal of the Chicago Board Options Exchange was to tell market participants the expected amount of volatility during a 30-day target timeframe. Getting into the details of calculating the VIX involves high-level math, but the basic idea is fairly simple. Options prices are based on several factors, one of which is the investor’s expectation of how volatile the underlying market will be between now and the date on which the option expires. All other things being equal, if investors expect a flat market, they won’t pay as much for options designed to profit from wide market swings. If they expect a big move, though, then options prices will go up even if everything else — such as the current level of the underlying market index — stays the same.
In 1929, 2000 and 2008, stock prices soared to absolutely absurd levels just before horrible stock market crashes. What goes up must eventually come down, and the stock market bubble of today will be no exception. In fact, virtually everyone in the financial community acknowledges that stock prices are irrationally high right now. Some are suggesting that there is still time to jump in and make money before the crash comes, while others are recommending a much more cautious approach. But what almost everyone agrees on is the fact that stocks cannot go up like this forever.
Michael Paulenoff is the president of Pattern Analytics. He told Business Insider that there are some indications that a correction is on the horizon. He said declining volume in the stock market is one red flag.
The current position of the Chicago Board Option’s Exchanges Volatility Index — or VIX — is an indication that the stock market is unhealthy. The VIX is basically a measure of expectations for future stock volatility, so when stocks are rising, and people feel good, the VIX moves lower. During a sudden selloff, it spikes.
In August 2015, a 1000 points correction gets VIX up to nearly $60 from $10 in a month. Same is the case now as the markets are extremely bullish but trust in stock market is still fragile. This time around the VIX can climb up to $100 due to FED and Trump policies (tax cuts and stimulus) could disappoint and economy will be at danger of recession.
Right now the VIX is at 11.47, down from where it stood the day before the Presidential election — after which stocks began a determined push higher that took all three US benchmarks into record territory. But Paulenoff said the current levels are actually mismatched. The VIX isn’t low enough. “The VIX is all messed up,” Paulenoff said.”We are somewhere around 11 and 12 when we should be at 8.” In a recent note, he noted that the VIX has actually climbed in February even as the S&P 500 rose to record highs. He noted that this suggests “extreme caution” among stock investors.
Bottom line is that with rising debt levels in the economy, investors are going to be extremely fearful in case of upcoming stock market correction and that could lead the VIX to touch the $100 points level in the days to come. This extreme volatility may well can lead to the stock market crash as was witnessed in the eve of 2008 crisis.
by Umar Farooq