A true bear market rarely occurs without a recession. We saw an exception to that rule in 2011 after the U.S. Treasury’s debt was downgraded by Standard & Poor’s. However, as we would have expected, those losses were significantly reduced by the end of the year.
Even the “Black Monday” event of 1987 merely interrupted the trend, and the market still closed higher for the year. This is typical during non-recessionary periods, even when the market drops more than 20% into bear-market territory.
If we accept that a slight correction in the S&P 500 followed by a bounce is more likely than a true bear market, we can start thinking about how to forecast support. Following Monday’s flash crash, the major indices have attempted two bounces already. Has volatility reached a point where it is truly “too high,” or is there more to the downside?
Volatility Measures Suggest Rebound, Not Recession
No one can forecast the markets perfectly. However, we can often get pretty close by watching volatility levels in the options market. The most effective tools for this kind of analysis are the 30-day and 90-day CBOE volatility indices. The shorter version, the CBOE Volatility Index (VIX), is familiar to most traders. The longer-term volatility index, the CBOE 3-Month Volatility Index (VXV), is also extremely useful as a benchmark to determine whether volatility is too high or too low.
The two volatility indices will move in the same direction on a day-to-day basis, but they move at different rates as investors try to price different expectations for 30-day or 90-day volatility. For example, if investors expect a lot of volatility over the next month, but they are more optimistic for the coming quarter, then the short-term VIX will rise more than the VXV. If the opposite is true, then the VIX will drop more than the VXV.
We can graph this relationship between short-term and long-term volatility and watch for extremes using a relative-strength analysis. As a general rule of thumb, we usually look for a relative-strength line between the two indices to approach the annual high (bullish) or low (bearish) when trying to determine whether volatility is likely to change in the near term.
In the next chart, you can see a relative-strength comparison between the VIX and the VXV plotted below the SPDR S&P 500 ETF (SPY). The study spiked beyond even the highs from October’s correction following the market’s crash on Monday. We should wait for the study to turn lower, which it did on Aug. 25, to signal that volatility has become overblown and is likely to fall. This is a surprisingly accurate indicator for timing the end of market corrections.
If we assume that the current decline isn’t the start of a bear market, traders should start looking for dip-buying opportunities.
SPDR S&P 500 (SPY) With VIX /VXV Relative Strength
If you apply this study to the S&P 500 over the last several years, you will note that those highs act as an accurate indicator the majority of the time. However, it often leads the subsequent rally by three to seven trading days. So, while we have significant evidence that volatility is “too high” and is likely to reverse, a bullish rally may not happen until next week.
This study works the other way as well. When the comparison gets near its 52-week lows, we would expect that volatility is “too low” and is likely to reverse. This is a more effective analysis when the major indices aren’t in a channel, but it is still a very accurate indicator for timing the end of a bullish trend.
From a fundamental perspective, we know that the global economy (including China) isn’t in a recession. A true bear market is possible, but it’s very unlikely. It will be more productive to spend time trying to forecast the eventual bullish bounce than a bear-market bottom. Volatility comparisons have turned the corner, and the market looks like it has reached a point where prices are “too low.” This puts us in an interesting position.
On the one hand, a reversal would be great, and traders can make a lot of money with some bullish bets. However, on average, it takes a few trading sessions for that reversal to occur following the initial signal. Ultimately, the opportunity to make some profit from a bounce outweighs the potential short-term choppiness the market is likely to experience.
InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.
You can learn more about identifying price patterns — including bearish continuation patterns — and using them to project how far you think a stock is going to move in their Advanced Technical Analysis Program.
