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VIX Near 5-Year Low - Will This Jinx the Stock Rally?

Simon Maierhofer

The VIX (Chicago Options: ^VIX) or fear gauge is at the lowest level since July 2007. Not only are investors complacent about any possible risk, but the financial media is too complacent to write about investors lack of fear.

Lack of publicity of a bearish indictor usually increases the potency of its message. Does this mean the stock rally is about over?

There are no absolutes at investing, but low VIX readings have proven to be a good sell signal. Since July 2007 the VIX dropped below 15 only twice - in April 2011 and a few days ago (Tuesday's low was 13.99, the April low was 14.30).

We know that last April's VIX low led to a swift 20% across the board decline, but to get a larger sample size, let's relax the parameter to VIX readings below or close to 15. This gives us a few more hits. The chart below plots the S&P 500 against the VIX.

The horizontal red line is drawn at the 15 level while the red arrows mark the corresponding S&P level. It doesn't take a Ph. D. in statistics to decipher the implications of a sub-15 VIX reading.

Versatile VIX

In addition to its correlation to stocks, the VIX viewed in tandem with the upper or lower Bollinger Band provides actual buy/sell signals (a buy signal for the VIX translates into a sell signal for stocks).

A close below the lower Bollinger Band followed by a close above triggers a VIX buy signal (sell signal for stocks).

The ETF Profit Strategy Newsletter alerted subscribers of a stock sell signal on January 12, 2010, April 13, 2010 and April 25, 2011. As illustrated by the chart, each such sell signal was followed by a decline ranging from 10 - 30% in the major indexes a la Dow Jones (), S&P (), Nasdaq () and Russell 2000 (Chicago Options: ^RUT).

A buy signal for stocks was triggered on October 4, 2011, which was two days after the ETF Profit Strategy Newsletter issued a strong buy-signal and described the ideal scenario for a major market bottom as follows: 'The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.'

Short-term Outlook

As pointed out by Sunday's ETF Profit Strategy forecast for the week ahead, seasonal strength before triple witching tends to provide a boost for prices. Once triple witching is over, the seasonal strength gives way to end of quarter rebalancing volatility, which more often than not means lower prices.

This doesn't mean stocks can't go any higher, but just as a sore throat often leads to a cold, an ultra-low VIX reading can easily lead to a pronounced sell off.

In addition to the market's VIX trouble, Apple seems to be carving out a rare topping pattern seen in gold (NYSEArca: GLD - News) and silver (NYSEArca: SLV - News) last year. Apple accounts for 18.44% of the Nasdaq-100, the index that has led the market and is the biggest component of the S&P 500. If Apple catches a cold, the market will get the flu (and perhaps pneumonia).

It's too early for conservative investors to trade based on any of that information (aside from scaling down long positions), but there's strong evidence that any weakness that pulls stocks below important support will no doubt awaken sellers.

The ETF Profit Strategy Newsletter analyzes Apple's topping patterns and what it will take to confirm that the pattern is playing out. It also provides the must hold support that - once broken - would result in heavy selling and much lower prices.

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