VIX Up 25% After Falling to 5-Year Low - What Does This Mean?

On March 15 the VIX (Chicago Options: ^VIX) fell to 13.66, the lowest reading since June 20, 2007. Since then the VIX has spiked as much as 25%.

What's particularly interesting is that not only have investors become complacent about any type of risk, the media has become complacent about investors complacency. I don't recall reading a single high profile article suggesting that such a low VIX reading could be troublesome.

While not an absolute short-term indicator, lack of publicity of a bearish indicator 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..

We know that last Aprils VIX low led to a swift 20% across the board decline, but to get a larger sample size, lets 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 doesnt 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 (DJI: ^DJI - News), S&P (SNP: ^GSPC - News), Nasdaq (Nasdaq: ^IXIC - News) 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

On March 12 the VIX dropped below the lower Bollinger band once again. This market the closing low for the VIX.

Despite the buy signal for the VIX, this didn't quite yet look like a sell signal for stocks. The ETF Profit Strategy Newsletter pointed out that a strong seasonal bias going into triple witching (March 16) and end of quarter window dressing tend to keep a bid under stock (NYSEArca: VTI - News) prices.

Nevertheless, there are warning signs. Apple seems to be carving out a rare topping pattern seen in gold and silver 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).

Its 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.