When This Stock Market Signal Flashes, It's Time to Get Short

Periods of low volatility in the stock market are always followed by periods of high volatility. Always.

It's as certain as spring following winter.

Of course, when you're suffering through temperatures that would make an Eskimo shiver, it's hard to remember spring is on its way. And when stocks are a one-way bet, when the market moves higher day after day in unending bullishness, it's hard to imagine it moving in the other direction.

But it always does. You can bet on it.

By the look of the Volatility Index (VIX), the market may be about to change temperature...

The blue lines on the chart are the Bollinger Bands. They indicate the range of volatility on a chart. When the Bollinger Bands squeeze closer together, as they're doing right now, it indicates a period of contracting volatility. When they expand, as they did back in May, it indicates a period of high volatility. One always follows the other.

The bottom graph charts the width of the Bollinger Bands. The width is now as narrow as it was last April – just before the "flash crash" and the start of a 20% correction in the S&P 500. There are many other similarities between today's market environment and that of last April. Investor sentiment is wildly bullish. And there are multiple technical divergences.

The biggest warning sign, however, is coming from the VIX and the contracting Bollinger Bands. This condition existed for several weeks last spring before stocks finally got hit. So the bullish party may continue for a little while longer.

Now is definitely not the time to get complacent. Keep an eye on the VIX. When the Bollinger Bands start to expand, we'll know the long awaited correction has finally arrived. Long-term investors should head for the sidelines. Short-term traders can speculate with short sales and put options.