Global Outlook

Is An “Overbought” VIX Good News For Stocks?

Contributed by eResearch

I recently decided to play with some VIX numbers. I used the CBOE Market Volatility Index (INDEXCBOE:VIX) more than 20% above its 10-day simple moving average (SMA) as a proxy for “overbought”. This is not some magical number or anything – it is just a level that the VIX does not attain all that frequently, so a good breaking point.

Anyway, here is what I did. I looked at the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) returns one month and three months out every time the VIX closed more than 10% above its 10-day SMA. Once the VIX hit the 20% threshold, I ignored any further violations until that time period passed, so as to not over-count the same samples.

I went back to the listing of SPY in February 1993, and found 46 distinct occurrences where VIX closed "overbought." Again, it happened more than 46 times -- I just eliminated subsequent occurrences within a month.

Of those 46 times, SPY was higher one month later 31 times. It averaged a 1.6% rally, with a median of a 1.8% rally. That is far from cosmic, but it is considerably better than the 0.9% average rally the market saw in a typical month, according to Hulbert's work.

It was not without its "accidents." If you went long on the Sept. 15, 2008 overbought VIX signal, you got Lehman-ized to the tune of a 24.8% one-month hit. Then again, one of the better buy signals this indicator delivered occurred not much later. A SPY buy on Nov. 20, 2008 netted a nice 15% return in a month. The best, however, was a 20.9% pop one month after the overbought VIX signal on July 23, 2002.

In other words, this is more evidence that numbers from the fall of 2008 were the definition of outliers. Lop both these off, though, and it doesn't change the picture much. Going long for a month when the VIX got overbought was a value-added strategy.

The VIX-di-cater added value going long for three months as well. There were 30 distinct instances of overbought VIX, and the SPY was higher three months later 23 times. The mean gain was 3.3% and the median gain was 4.4%, versus an average three-month gain of 2.9% on a "normal" day. That same signal on Sept. 15, 2008 was the disaster, producing a 23% loss over three months. The best gainer was a 15% pop after the Oct. 27, 1997 VIX-Fest.

I did not go further out because, frankly, six months later is an awful long time to read much into a VIX lift.

I have said this before and I will say it again. The experience of 2008 changed how many view the VIX. Prior to that, the VIX was considered a contra-tell. High VIX meant too much fear, which meant the selling was at an extreme. Post 2008, the VIX suddenly became a leading indicator.

None of this is to say you should go long every time the VIX explodes. Yes, it is a sign of an oversold market, but oversold markets are the ones that crash. Not all oversold markets crash, but all crashes start from oversold conditions. 2008 was essentially a market crash, just not one that played itself out in one session.

Crashes are low-probability events. So I would suggest that VIX pops in the middle of otherwise placid markets are more likely than not good entry points on the long side.