- This fear indicator has been extraordinarily accurate at forecasting market bottoms.
- On Monday, it hit its highest level since mid-May.
- Many investors panic sold in May … but the S&P 500 Index bounced back.
I’m a creature of habit.
It’s not that I don’t like spontaneity every once in a while. It’s just that I fare better as an adult when I stick to my daily routine.
All the self-help gurus stress that a morning routine is key to setting your day up for success.
Mine includes a brisk morning walk with the pups, followed by a light breakfast while devouring the day’s financial news. Afterward, I try to get the blood pumping with a short run or swim before sitting down to take on the day’s market-related writing tasks.
These are the same morning activities that kept me grounded and productive as a trader, and I still maintain them today.
I’m sure you have your morning routine that leads to a more rewarding day as well.
I also have a routine process for what to do when the market sells off, especially when volatility is prevalent and everyone is losing their minds.
This week, one of my indicators came as close as you can get to a major buy signal.
And you won’t hear about this on TV.
In fact, you’ll be surprised when I show you that everything you might have heard on TV about popular volatility indicators is wrong…
How Not to Think About Volatility
I’ll admit, every now and then, I tune into the financial news networks to see what pundits are talking about.
I don’t watch TV for the news. I watch it to see how pundits react to the news.
And when markets are volatile — as they’ve been in the past week — the talking heads on TV love to highlight the CBOE Volatility Index, also known as the VIX.
During the financial crisis, they kept it in the little bottom-right corner box with the prices of the Dow Jones Industrial Average, Nasdaq Composite Index and S&P 500 Index.
The VIX measures the prices of option premiums on the S&P 500. In a nutshell, it tells you how much volatility traders expect over the next 30 days.
When VIX prices are high, traders expect rocky markets. When they’re low, traders anticipate smooth sailing.
You can probably guess where they’ve been in the past week.
But the way investors look at and use the VIX is completely wrong.
A Better Indicator of Panic
Think of the VIX like a car insurance premium.
When the VIX moves up, it becomes costlier to insure a portfolio of stocks. A higher VIX suggests that investors expect danger ahead.
This is similar to how car insurance premiums move higher if the insurance company sees you live in an area with more car thefts and accidents.
But these insurance premiums don’t tell the full story.
What I care about is how quickly the price of insurance is moving higher. That’s a better indicator of fear.
And to do this, I look at the volatility of volatility, or the VVIX.
When the VVIX spikes, it indicates that the cost to insure the market is quickly moving higher, as investors willingly pay higher prices.
And when everyone is reaching to buy insurance at the same time, it indicates that there’s a panic happening.
When people panic, they often act irrationally, such as by overpaying for insurance … or selling stocks at the bottom of the sell-off. And that’s when strategic buyers can profit from investor panic.
The Best Fear Indicator to Watch
In the past five years, the VVIX has been extraordinarily accurate at forecasting market bottoms.
Since January 2014, there have been nine occurrences when the VVIX crossed above 120.
And in eight out of the nine times the VVIX has moved over 120, the three-month return of the SPDR S&P 500 exchange-traded fund (NYSE: SPY) was positive, with an average gain of 5%.
In March of last year, the VVIX crossed 120. Over the next three months, SPY returned 6.8%. It then followed that rally with another 6.6% rally over the following three months, for a cumulative 13.4% gain.
The VVIX reached 210 on August 24, 2015 — the day the Dow crashed 1,000 points on the open, only to recover later that day.
The latest reading above 120 happened on October 15, 2018.
Now, this wasn’t the bottom of last year’s sell-off — no indicator is perfect. The market bounced after that day and then sold off again in December.
However, if you bought SPY that day in October, you still would have shown a positive return six months later.
In mid-May, the VVIX reached 117. That led to a 3.5% bounce before another market sell-off that ended on June 3.
From June 3 to July 26, SPY returned 9.1%, to the chagrin of investors who had panic sold in May.
Get Ready to Buy the Next Spike
With the recent market sell-off, investors are again reaching for insurance, and again, this is an opportunity to profit from investor panic. The VVIX spiked again in the past week. Although it didn’t quite reach 120, it hit 115 on Monday.
And it didn’t take long for a bounce to happen. As I’m writing this, SPY is now trading at $292.50, almost 4% above Monday’s low.
Perhaps we continue higher from here. Or perhaps the market rolls over and we get another spike in the VVIX.
Either way, I’m ready to buy the next spike in the VVIX.
Like the creature of habit that I am.
Editor, Automatic Fortunes