The Volatility Index (VIX) generated its first buy signal of 2020 yesterday.
Buy signals occur when the VIX closes above its upper Bollinger Band – indicating an extreme increase in volatility – and then closes back inside the bands. We’ve followed these signals plenty of times over the past few years, and they’ve proven to be quite profitable.
This time, though, I’m not buying it… at least not yet.
The problem is the current market looks a whole lot like what we saw back in January of 2018. Back then the market rallied just about every day. Overbought conditions got more overbought. And, the VIX languished at a relatively low level.
That condition isn’t sustainable. I spent a lot of January 2018 warning traders about the risks of a sudden and sharp move lower. And, just like the past month, I spent a lot of time banging my forehead on my desk.
Stocks finally did pull back. It took only three days for the S&P to wipe out all its gains for the month. The VIX spiked higher and closed above its upper Bollinger Band – setting the stage for a buy signal.
That buy signal occurred in early February 2018, when the market bounced off short-term oversold conditions. Traders who bought stocks on the basis of that buy signal would ultimately be profitable. The market pressed higher over the next few weeks.
But, over the next few days, it was painful. The market sold off even harder. The VIX spiked even higher… reversing its premature buy signal and trapping traders who had acted on it underwater.
Here’s a chart of the VIX from early 2018…
The first blue arrow points to the premature VIX buy signal. As I mentioned, folks who bought into that buy signal eventually turned out just fine. But, it was the folks who bought into the second buy signal (the second blue arrow) who nailed the biggest profit.
That’s what I’m looking for this time around.
The stock market has been on such a relentless run higher. And, investor sentiment reached extremely bullish levels. I’m not convinced that a 3% decline in two days is enough of a correction to set the stage for another leg higher for the stock market.
Yes… the market did wipe out all its gains for the month. Yes, many technical indicators did stretch into extremely oversold territory. And yes, the VIX did generate a buy signal yesterday.
But, if the market continues to follow the same script it played in early 2018, then stocks still have some work to do on the downside. Rather than chasing yesterday’s big rally higher, traders might be better off waiting to see if we get a shot at a second VIX buy signal in the days ahead.
Best regards and good trading,
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