Beware the Falling VIX in December

Wall Street’s so-called fear gauge, the CBOE Volatility Index (CBOE:VIX), has experienced a stunning decline so far this month, but investors need to be extremely careful about what they read into this. December VIX performance is notoriously unreliable and prone to reversal, and at this point it may actually be a contrary indicator for the broader market.

The VIX declined into the low 20s on Wednesday morning, compared with its level of 30.91 on Dec. 8 — just nine sessions ago — and a recent peak above 35 on Nov. 21. Notably, this move hasn’t been accompanied by a major upturn in the market. The S&P 500 is virtually unchanged from its Dec. 8 low through early on Dec. 21, and it’s up only 4.5% since Nov. 21. With so little movement in the market, why the big move in the VIX?

The answer is seasonality. The VIX has a strong downward bias in December, due to the high number of holidays and slow trading days in the 30-day forward window it captures. According to the blog, the VIX has hit its calendar-year low in the week before Christmas in five of the past eight years. During this time, the VIX has its low on Dec. 24 once, Dec. 23 twice and Dec. 18 once. It’s a remarkable, high-probability trend that doesn’t get nearly as much attention as it should.

Three other key points to consider amid the flood of reporting we’re likely to see about the collapsing VIX in the days ahead:

Europe’s Still on the Ropes: The main reason for the elevated VIX that has been in place during 2011’s second half is, obviously, the concerns about a worst-case scenario unfolding in Europe. And during the past week, no fundamental changes in the Continent would warrant such a decline in the VIX. If anything, the situation has gotten worse with the talk of potential downgrades to France and the U.K. This is confirmed by the iShares MSCI Europe Financials Sector Index ETF (NASDAQ:EUFN), which has nearly round-tripped from its October rally and is within striking distance of new lows. Typically, this kind of disconnect between VIX performance and the underlying fundamental trends concludes with an upward reversal in the VIX.

December VIX Drops Usually Prove Short-Lived: During the past 10 years, the VIX has closed on Jan. 31 above its low of the previous six weeks in every year. The exact timing of the low point can vary: While it frequently occurs around Christmas, in several years the index didn’t put in its low until the first or second week of January. The takeaway is that while picking the low can be difficult — and when isn’t it? — the trend for the VIX in January is clearly upward.

Falling VIX Caps Market’s Upside:  The VIX’s current decline should be seen as a caution flag for the broader equity market. As long as it’s at this level, stocks could have a difficult time making significant headway. The basis for this assertion is that upside becomes more limited the lower the VIX goes, and it’s difficult to see the index falling into the teens with Europe’s problems representing an ongoing threat.

A Trade in the Volatility ETFs?

Typically, the VIX-related exchange-traded notes (ETNs) are extremely difficult to trade. If you’re off the mark by a couple of days, the resulting drawdown can be challenging to overcome even if your thesis ultimately plays out. The result is that the potential to be right on your call and still lose money always has an uncomfortably high probability with these ETNs. That said, the strength of the seasonal trend indicates that this could be one time that the VIX ETNs may actually be a smart trade. Consider buying the Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) or — for the extremely risk-tolerant — VelocityShares Daily 2x VIX Short Term ETN (NYSE:TVIX). These just may be the ticket to starting off the 2012 trading year on the right foot.

As of this writing, Daniel Putnam is long TVIX.

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