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[Pata-Hari]

Defending the VIX
by David Nichols

Since I feature the VIX so heavily in my work, it's only appropriate that I come under fire when the VIX itself is not doing so well as a market timing tool. This has been happening a bit lately, but I'm not complaining. Every really valuable indicator has to fall by the wayside once in a while in order to replenish its store of value. Right now, it's the VIX's turn.

I'm also getting lots of comments about how the VIX "can go down into the teens, and stay there for a long time". That's true, I guess. Anything is possible. More specifically I'm hearing lots of comments about how the VIX can go to 12, and live down there for years, as it did in the early 90s.

All I can say to that is: Does the current world resemble the early 90s? Are we about to accelerate into the biggest financial bubble of all time? Personally I feel it's a major analytical trap to compare what happened in the biggest, wildest bull market of the century (the 90s), to what is happening in its bear market aftermath. If anything, we should be looking for indicators to do the exact opposite of what they did in the bull market. That is, if the VIX lived in the low teens for years on end during the bull, then we can not realistically expect a repeat performance of that, but rather the VIX to live in a very high range for years at a time.

I'm also perfectly happy to be the last man standing that thinks the VIX in the teens is a major, juicy shorting opportunity. That suits me fine. That's exactly what is needed, in fact. When somebody brings up how the "VIX can go to 12" or "everybody knows about the VIX, so it doesn't work anymore" (I got a lot of that one in February 2001), I just smile and nod my head sympathetically.

I'm not going to lose faith in this magical sentiment indicator, because I'll let you in on a little secret. You didn't even need to look at a price chart over the last few years to be the best market timer in the world. All you needed was a daily chart of the VIX. Although it's always, always easier in retrospect, in real-time I actually did manage to rack up 250% cumulative gains trading in and out of the Rydex Dynamic Funds over the last 2 years -- without a single loss -- using not much more than this very chart.



It took me a long time to get to a point of such simplicity and clarity. And trust me, I've looked hard at everything. But in the markets, complicated is definitely not better. In fact, the more indicators you look at, the more wiggle room you give yourself to craft a thesis to fit the particular mood you're in -- a mood which usually corresponds very closely to the consensus opinion, by the way. For me, it's much simpler and more effective to just follow the general guideline: "VIX high, buy; VIX low, sell".

It works. That's what counts. Is it foolproof? No. But it's pretty darn close.

Okay, okay, that's all well and good you're saying -- but the VIX doesn't seem to be working now. It has gone low, and stayed low, as the market meanders to the upside. The answer to this quandary is it's not over yet, not by a long shot. The market always looks and feels great right at the top, when everybody is already on board, and the VIX is under 20, as it is right now.

The Bulls can't declare victory and a "new bull market" until they've survived a truly scary test that takes the VIX back up over 30, or even to 40 or higher. If that happens, and the market is significantly above the bear market lows, then we may really be onto something to the upside. But we won't really know what this market is actually made of until we see how that sentiment swing plays out.

People so much want to believe in this market. They are practically willing it higher. Money supply growth is just ridiculously high, as the Fed continues to pour as much kerosene onto the fire as possible, hoping something incendiary will spark to life. Inevitably some of this liquidity finds it way into the stock market, but Greenspan and Gang are losing their traction in this department. Money supply has been growing at a staggering rate, yet the market can only churn and grind. That's definitely not bullish.

Also not bullish is the action in commercial paper, which the Fed tracks scrupulously every day on their web site. That blue line is non-financial commercial paper "outstandings", and it's just been in free-fall since the bear market started. It's actually at the point now where companies are only borrowing as much as they need to fund ongoing operations, in spite of the Fed's massive stimulus. We're still waiting for that blip up in corporate spending, but it's just not happening.





So we're left with a market that everybody loves and a VIX under 20, and I'm hearing early reports that short interest figures continue to drop (we'll get more information on this soon from Phil Erlanger, who has all the data on this...) This is a main reason why the market can't really take off to the upside -- the bears are all blown out. Maybe the market needs to cleanse the decks even more fully by a trip up to SPX 1040 with further erosion on the VIX, but that's not going to change the eventual outcome, which involves a scary trip back down and a soaring VIX. That's just the way it works.

Sentiment Dashboard
by Adam Oliensis



SENTIMENT TANK: Drained to 0% full of negative sentiment on Thursday, which is to say it's completely empty. Sentiment is at its most bullish in a year.

SHORT-TERM: Remains neutral with a positive bias.

MID-TERM: Progressed 5 points to 81% on the advance side. The confidence level decreased to a bullish 1 (out of 7). However the 81% level takes the gauge out of the yellow box in which it has been caught for a couple of months, which is to say that the momentum of sentiment has been (along with the momentum of price) stronger on this recent rally leg than otherwise during the summer consolidation.

LONG-TERM: Remained essentially neutral at 93/7 but with a bullish bias and a confidence level of a bullish 2.

BOTTOM LINE: The market is on the cusp.. Either it has to change phases and really launch into the next rally leg and tell us that this is an early stage of a NEW and IMPORTANT BULL MARKET in which sentiment plays an entirely different roll than it has played over the past 3 ½ years, or else the market will reverse and head down, rousing significant fear and filling the tank with the magic elixir of negative sentiment fuel.